The last six years of extraordinarily low interest rates have been all about rewarding borrowers at the expense of savers. But that is probably coming to an end.
If the Federal Reserve begins raising short-term rates by year's end, as anticipated if the economic expansion continues, the costs of many forms of debt will rise from current super-cheap levels.
The increases probably would be modest at first, tracking what's expected to be a go-slow policy by the central bank. Still, any boost in borrowing costs would be painful for indebted consumers and small-business owners who have suffered meager income growth in recent years.
U.S. consumer debt other than home loans hit a record $3.38 trillion in May, Fed data show.
Although the debt load fell initially during the 2008-09 financial crisis, it quickly began to rebound, paced by student and car loans.
For many Americans, debt is affordable and makes sense at these low rates. But now's the time for borrowers to look at what they owe and figure out how much their interest costs will rise if the Fed begins to lift rates, said Greg McBride, chief analyst at rate research firm Bankrate Inc. It's far better to plan than to face sudden payment shock.
The best strategy in the face of higher rates is to pay down debt, if possible. Barring that, there are other ways to make rising rates easier to bear.
Here's a look at the most common consumer and small-business borrowing tools and what to expect once the Fed begins to lift rates:
•Credit cards: Plastic debt typically is the most expensive debt, and it will get more so with every Fed rate increase. That's because "the vast majority of cards are variable-rate now, not fixed-rate," said Matt Schulz at online card marketplace CreditCards.com. Variable-rate cards charge floating interest rates that are pegged to short-term market rates — most often, to banks' so-called prime lending rate.
The prime, in turn, takes its cue from the Fed's benchmark short-term rate, known as the federal funds rate. The Fed has held the federal funds rate near zero since the financial crisis deepened in December 2008. Banks' prime rate has been at 3.25% since then.
If the Fed raises the federal funds rate to 0.25%, banks are expected to quickly lift the prime rate to 3.50%. Credit card rates generally should rise by 0.25 percentage point as well, and continue to move up in tandem with any successive Fed increases.
Card rates currently average about 15% nationwide, though people with bad credit can pay 22% or more, according to CreditCards.com. So as a percentage of what borrowers already are paying on outstanding debt, a few quarter-point Fed boosts won't add much. Still, if you're carrying a balance on your card, consumer finance experts advise checking the fine print so you're aware exactly how much your rate will rise.
This also is a good time to consider finding a better card deal, McBride said. For example, if you have a large card balance, some issuers will allow you to transfer it to their card and pay zero interest on the balance for a set period, sometimes a year or longer. That could add up to a lot of interest savings, particularly if card rates start rising quickly.
•Home equity credit: Loans secured by the equity in a home also tend to be pegged to banks' prime rate. Many home equity loans now charge annualized interest of 6% to 8%, according to Bankrate.com. If the prime rises, home equity loan rates will match those increases.
The advantage of these loans over other credit is that the interest is tax deductible, just like mortgage interest. So using equity loans to pay off other debt has long made sense.
But there's a catch for many equity borrowers: Loan agreements made before the housing crash typically allowed borrowers to pay only interest for the first 10 years. That means those borrowers are reaching the "reset" point at which they must begin paying principal as well as interest on outstanding debt, notes Keith Gumbinger, vice president at mortgage-industry tracker HSH Associates.
If interest rates start to rise, that will be a double-whammy for those borrowers.
If you're facing a payment that will be hard to handle, you have options. One is to try to refinance the home equity line and any first mortgage into a single new mortgage at a fixed rate. The federal Consumer Financial Protection Bureau offers other loan advice on its website, at http://www.cfpb.gov. Search for "HELOC" on the site.
•Student loans: Education financing has mushroomed faster than any other form of consumer debt since 2008, to a record $1.36 trillion, according to Federal Reserve data.
The good news is that federal student loans have rates that are fixed for life, so rising market interest rates won't worsen the burden of outstanding loans for students or their parents.
Rates on new federal loans each year are determined by a formula set by Congress in 2006. The rates aren't pegged to short-term market rates but rather to the interest yield on the 10-year U.S. Treasury note, a popular benchmark for long-term rates.
Rates for new loans change each July 1. The rate on federal undergraduate loans taken out between now and July 1, 2016, is 4.29%. For standard graduate loans, the rate is 5.84%.
Those still are relatively cheap loans. But if market interest rates rise in the next few years, students who are years away from their degree should expect rates on new loans to increase as well, notes Rick Ross, whose company College Financing Group in Rochester, N.Y., provides college financial planning. "Preparedness is the key," he said.
That is crucial with privately funded student loans, which unlike federal loans often have variable rates, typically tied to banks' prime lending rate or other short-term market rates. Students or parents with those loans should check their contract to see how quickly those loan rates will rise if market rates begin rising.
Federal student loans should be the first stop for students and families because of the loans' many advantages — including that repayment is delayed until after graduation, Ross said. For full details on federal loans, go to http://www.studentaid.ed.gov.
•Car loans: Zero-percent loans have long been a staple for car companies, and have helped keep sales robust in recent years. That could change if the Fed makes money more expensive for the companies and their financing arms.
But the carmakers also have leeway. They could, for example, maintain the cheap lending rates and make up the interest expense by raising car prices, notes McBride of Bankrate. Either way, of course, the car buyer pays.
Whether dealer-financed or bank-financed, car loans typically are fixed-rate loans. But borrowers should check the loan contract. Some loans are variable rate and tied to banks' prime rate.
•Mortgages: Conventional home loan rates take their cue from long-term government bond yields rather than from short-term interest rates.
And while long-term interest rates can move up in tandem with short-term rates, long-term rates also can go their own way. It's a complicated relationship.
Here's why: Long-term rates are set by the market rather than directly controlled by the Fed. When investors are determining the fixed yield they're willing to accept on, say, a 10-year Treasury note, one key concern is the long-term outlook for inflation — because the "real" yield is the nominal yield minus whatever inflation eats away each year until the note matures.
If the Fed starts raising short-term interest rates, it could set the scene for lower long-term rates rather than higher rates if investors begin to believe that tighter credit will slow the economy and lead to lower inflation rates in the next few years. In that sense, "The long end of the bond market wants the Fed to tighten," says Jeffrey Gundlach, head of money manager DoubleLine Capital in Los Angeles.
But leading up to a Fed rate hike, investors often push long-term rates higher as well. That has been happening this year: The 10-year Treasury note yield bottomed at 1.64% in February, when the U.S. economy was weakest. It has since rebounded to 2.39% as of last week. In turn, the average 30-year mortgage rate has risen from 3.6% in January to 4.08% now.
Not surprisingly, the trend has helped boost home sales as potential buyers fear they'll lose out on low rates. U.S. existing home sales in May were at the highest pace in six years, according to the National Assn. of Realtors. If you're looking to buy and also think the economy will continue to strengthen, it obviously makes sense to get in sooner rather than later.
For the relatively small number of homeowners who have adjustable-rate mortgages, rising short-term interest rates would mean higher payments on the horizon. But many of those borrowers who took the risk of adjustable-rate loans have enjoyed extremely low rates since 2008 as the Fed has kept short-term rates near zero. "They've been living a golden life," Gumbinger said.
Even if short-term rates head higher later this year, Gumbinger notes that adjustable-rate loans may not rise immediately, depending on how the contract is written. Homeowners who don't want to take the chance of facing rising payments should start looking now at refinancing into a fixed-rate loan.