New Opportunities Arise for Borrowers
What’s the best way to borrow money when interest rates are falling? For Americans, who are more than $7 trillion in debt, billions of dollars in interest costs ride on the answer.
In the wake of Tuesday’s half-point rate cut by the Fed, major banks cut their prime lending rate to 7%--the lowest level in seven years. Consumer loan rates, already dropping thanks to earlier Fed moves, probably will follow suit, giving consumers the opportunity to save money by refinancing their debt with lower-rate loans.
“This is a great environment for consumers,” said Keith Leggett, chief economist with the American Bankers Assn. “They should be able to find much more favorable borrowing rates.”
But the most cost-effective way to borrow probably will hinge on whether you own a home, and how much equity you have in it, said Keith Gumbinger, vice president of HSH Associates, a Butler, N.J., interest rate tracking firm.
“If you have a home, you have a lot of options,” Gumbinger said. “If you don’t, you don’t have that many choices.”
Although mortgage rates have risen somewhat in recent months, they’re still about 1.5 percentage points lower today than a year ago, said Greg McBride, analyst with BankRate.com, a Florida-based rate tracking firm.
Also, rates on home equity lines of credit, many of which are tied to the prime rate, have fallen with the prime this year and continue to drop.
At current levels, rates for mortgages and home equity credit lines can mean big savings for homeowners who have more expensive auto or credit card debt and want to cut those costs by refinancing their current home loan or tapping their home equity.
The key appeal of borrowing against a home versus other consumer debt is that interest paid on home loans is tax deductible--further reducing your “effective” rate, or the total cost after taxes are considered.
For example, the effective rate on a 7% home loan for someone who pays 30% of his or her income in tax is just 4.9%, once tax deductions are taken into account.
What’s more, with the annual inflation rate at about 3%, the after-inflation cost of a home loan is relatively low, some analysts say.
Of course, rolling more debt into a home equity loan or line of credit isn’t a decision that should be taken lightly, because you’re putting your home on the line for debt that is otherwise unsecured. You need to be certain that you’ll be able to make the payments and are committed to not running up your credit card debt again, cautions Judy Martindale, a fee-only financial planner based in San Luis Obispo.
The big question a consumer may face is whether to refinance their entire home loan or simply get a home equity line of credit.
The home equity line of credit is the best option for those who have a relatively low-cost, fixed-rate first mortgage, Martindale said. That’s mainly because you can usually get a home equity line of credit without paying any upfront fees. If you refinance your home--paying off the first mortgage and replacing it with another at a lower interest rate--you’ll normally pay at least 1% of the loan amount in costs for appraisals, title insurance and the like.
On the other hand, home equity lines of credit are typically variable rate loans. That’s great in today’s declining rate environment, but not so great when rates start to climb again, said BankRate.com’s McBride. All things being equal, locking in a fixed-rate loan is better, he said.
Home equity loans are a bit less flexible than home equity lines of credit. With a home equity loan, you get the entire amount of the loan when the loan closes; with a home equity line of credit, you can borrow as the need arises, pay back all or part of the line and then borrow against it again.
It makes sense to refinance the entire house if you have an older, relatively high-rate loan--one with an interest rate of 8% or more, Gumbinger of HSH Associates said. Assuming you have enough equity, you can get cash out when you refinance to pay off all your other consumer loans.
One caution: If you fold your consumer debt into a home equity loan or a home refinancing, you are likely to be stretching out the payment term on the consumer debt over a longer period of time, Gumbinger said. If you don’t make a point of paying the loan faster than required, you’ll spend more in total interest costs by stretching the repayment term than you’ll save from the lower interest rate, he noted.
Those who don’t have a home to borrow against--or don’t want to risk losing their house if they can’t make their monthly payments--have fewer options, experts note.
You can refinance auto loans, McBride said. But you have to realize that you’re often going from a new car loan to a used car loan when you do. Used car loans are available, but usually at somewhat higher rates.
Meanwhile, anyone who carries a credit card balance but hasn’t shopped for a low-rate credit card lately ought to do it now. Introductory rates on standard credit cards now range from 2.9% to roughly 8%, according to CardTrak, a credit card rate tracking firm based in Frederick, Md. However, the average interest rate paid on credit cards still hovers around 17%, according to BankRate.com.
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Prime Rate at Seven-Year Low
Major banks followed the Federal Reserve’s half-point interest rate cut Tuesday with a similar cut in their prime lending rate, reducing it to a seven-year low of 7%. Many consumer loan rates are pegged to the prime. How that rate has changed since 1990:
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July 2, 1992: 6%
Feb. 1, 1995: 9.0%
May 17, 2000: 9.5%
Prime rate Tuesday: 7%
Source: Associated Press
