Q&A;: Ignore Wacky Interest Rates at Your Own Peril

Interest rates have gone wacky in the past few weeks--and consumers should take note.

Long-term rates--on both savings and debts--have dropped dramatically, while short-term rates are doggedly hanging on at levels near three-year peaks.

At the same time, the actual (as well as inflation-adjusted) spread between loan and saving rates has widened, making borrowing all the more expensive.

This unusual environment, where short- and mid-term rates are nearly identical, shakes economists because it could signal a recession.

But for consumers, it could spell opportunity--and serve as a reminder that some basic rules of finance are worth remembering.

The financial market is speaking, adds William C. Stevens, managing director at Montgomery Asset Management in San Francisco. “Ignore it at your peril.”

Here’s an overview.

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Q. What’s so unusual about today’s interest rates?

A. Under normal circumstances, you earn higher returns on longer-term investments. That’s simply because investors get compensated for taking risk. And your risk is greater when you lock money up for long periods than when you’ve invested for the short-term. As a result, if you plotted going yields for U.S. Treasury bills, notes and bonds on a graph with maturities on the horizontal line and yields on the vertical axis, you’d expect the resulting graph to curve upward. However, right now, part of the “yield curve” looks like a saucer--nearly flat, but somewhat higher at both ends than in the middle. If it dips in the middle, the curve is considered inverted.

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Q. How do Treasury yields affect loan rates?

A. The Treasuries are the standard for all market rates. Many of the rates you pay on most 30-year, fixed-rate mortgages are loosely tied to the market yield on 30-year Treasury bonds, for example. Meanwhile, many adjustable mortgages directly link the yield on one-year Treasury bonds.

Other market rates, such as prime--a short-term lending index that determines the rate you pay on everything from business loans to personal lines of credit and some credit cards--also tend to loosely track short-term Treasury yields.

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Q. What are the opportunities for me now?

A. For years, financial planners have been telling their clients to pay off or refinance their short-term consumer debt--that’s credit card, auto loans and personal lines of credit. That’s because interest paid on these debts is no longer tax-deductible and they’re fairly costly.

However, today’s interest rate environment and lower inflation makes the argument even more compelling. That’s because these loans are based on relatively high short-term lending rates.

Someone with a variable-rate credit card that floats at prime plus 9.9%, for example, would now be paying 18.9% on their debts. Paying that off with savings would be like earning 19%. And if they refinanced that into a fixed-rate home-equity loan, they would probably shave 9 or 10 percentage points off the interest cost, or between $900 and $100 for every $10,000 borrowed.

Also, because of lower inflation in recent years, the money you use to pay back loans is worth just about as much as the money you borrowed. Through much of the 1970s and 1980s, high inflation meant you paid back with much cheaper dollars.

If you have savings or unencumbered investments--those that are not tied up in an IRA, 401(k) or Keogh plan--seriously consider using the money to pay off your consumer debts, says Charles Foster, partner at the Del Mar, Calif.-financial planning firm Blankinship & Foster. If you own a home, you can also consider using an equity line of credit to pay off more expensive debt.

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Q. I realize I should use money that would otherwise be in a bank account to pay off high-rate debt. But all my investments are in the stock market. Should I sell to pay off debt?

A. “On average, the stock market has produced a 10% annual return--and that’s before tax with a lot of risk,” Foster says. “If you’ve got personal debt, the best investment for your dollars would be paying off that debt.”

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Q. What about retirement accounts? I know I’d have to pay a penalty if I withdrew money to pay off debts, but is it worth considering anyway? Or, should I just not make a retirement plan contribution this year and use the money to pay off my credit cards?

A. No on both counts, Foster says. First, most people get substantial tax benefits by contributing to a tax-favored retirement plan such as a 401(k), Keogh or IRA, which means the government is essentially subsidizing your contributions, he notes.

Many companies also “match” a portion of worker contributions to 401(k)s, which makes the effective return on these accounts very attractive in good times and bad. It would be foolish to give up the matching amounts. Moreover, retirement investments are long-term. You shouldn’t fool with them because of short-term swings in the financial markets. Besides, Foster says: “If you don’t put the money in the 401(k) or Keogh, there’s a very good chance that you’ll spend it on something else and still not pay off your debt.”

The bottom line: It’s probably smarter to leave retirement savings--and strategies--alone.

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Q. I don’t have consumer debts, but I have a mortgage. Should I try to pay that down?

A. If you’re planning to stay in the house for a while, a better option is to refinance, notes Gary Schlossberg, senior economist at Wells Fargo Bank in San Francisco. That’s because long-term rates are down near their 20-year lows. That makes it an exceptionally good time to lock in a 30-year fixed-rate loan. Current rates for 30-year fixed mortgages are less than 8%. If your loan rate is higher, adjustable or you have other consumer debts that can be folded into the mortgage, it may be time to seriously consider it, he says.

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Q. I’m buying a home and I was thinking about getting an adjustable loan because the rates are lower and it’s easier to qualify. Should I be getting a fixed rate instead?

A. If possible, yes. The reason boils down to risk. When you get an adjustable mortgage, you are taking a greater share of the risk that interest rates will rise and you’ll pay more. As a result, you should expect to get a substantially lower rate on the front end. However, because adjustable loans are tied to short-term rates, which have risen, and fixed-rate mortgages are tied to the fast-falling long-term rates, the interest rate break you get on an adjustable is inconsequential today.

As of last week, the difference between the annual percentage rates on fixed and adjustable loans amounted to less than one-half of one percentage point at most national lenders. In more normal market conditions, where short-term rates are substantially lower than long-term rates, that differential amounts to between 2.5 and 3 percentage points.