Cut in Interest Rates Not a Signal to Increase Debt

Anne Viricel of Alta Loma appreciates the Federal Reserve’s tenacious effort to get Americans spending again by cutting the cost of debt -- but she’s resisting the lure of patriotic consumption.

The Federal Reserve has cut its key lending rate a dozen times since January 2001, including a surprisingly steep half-percentage-point cut last week.

Those moves, which have pushed banks to cut the cost of both short-term credit and home mortgages, have saved Viricel a tidy $500 a month in interest payments.

But she’s not spending.

Neither is Levon Jackson, a 21-year-old college student from Los Angeles who once was such a prodigious shopper that she racked up $6,500 in credit card bills before she even had a job.

Both Jackson and Viricel have been burned before by debt. Now, they’re using this period of historically low interest rates to get their financial houses in order.

That’s the savviest way to handle today’s low-interest environment, said Dianne Wilkman, president of Springboard, a credit counseling and debt management firm in San Bernardino.

“This is an opportune time to restructure your finances to put yourself in a better position,” she said.

Credit counselors say it’s a shame that there aren’t more people doing the same.

Retailers and economic policymakers are doing everything they can to keep Americans in the malls in an effort to jump-start the nation’s sluggish economy, because consumer spending accounts for two-thirds of U.S. economic growth.

The downside to this shop-for-your-country campaign is that Americans are increasingly indebted. The Federal Reserve reported Thursday that U.S. consumer debt jumped by $9.9 billion in September, up from a revised $5.6-billion gain in August.

The jump in debt is linked to simple math: Borrowing is cheap at today’s historically low interest rates. The prime rate -- the rate that banks charge their best customers -- hasn’t been this low since 1959.

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What Goes Down . . .

But consumers who are lured into spending lavishly because they think they can handle additional debt at today’s low rates could find themselves in a world of hurt when rates start heading back up, credit counselors say.

“People have started to develop an attitude that if the interest rate is low, it’s a good deal and they can afford it, without taking an independent view of whether they can afford the underlying item that they’re looking to buy,” said Tiff Worley, president of Auriton Solutions, a credit counseling company in St. Paul, Minn.

“If rates go up, or something changes in their lives, consumers risk being unable to make the payments,” he said.

The interest rates on many debts are fixed and don’t pose the threat of becoming unaffordable if rates start to rise. But some types of loans -- home equity lines of credit and many credit cards, for example -- have variable rates that will rise with the prime rate.

Interest rate increases aren’t a disaster for those who borrow modestly. But many consumers are woefully over their heads, and the Fed’s latest rate cut may push more individuals over the edge, debt counselors say.

“Is this new rate going to help stimulate people to buy and spend before the holidays? I think it is,” said Chris Viale, general manager of Cambridge Credit Counseling Corp. in Agawam, Mass. “That may be good for the economy, but it’s not good for consumers at all. We will see more spending and a much higher delinquency rate.”

Bankruptcies and foreclosures are at historic levels and consumer debt levels are near all-time highs. That underscores the fact that some consumers should not be assuming more debt, despite the declining cost of credit, counselors said.

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Restructure Debt

Instead, they should do what Viricel and Jackson have done -- take advantage of the low rates by paying off high-cost debt with lower-cost credit. Then use the money saved to pay down credit balances and save for emergencies and future goals.

Viricel, for example, refinanced the mortgage on her residence three months ago. That move saved her nearly $500 a month in interest costs. But instead of spending that money, Viricel is using it to pay off her mortgage.

At her current pace, the 44-year-old business manager will have the house paid off within three years. At that point, she says, she can decide whether to continue working or simply retire early.

“I used to buy things when I got extra money,” said Viricel. “Now I put the money toward paying off my house or adding to savings.”

Jackson doesn’t have a home, so she has pulled herself out of the malls. She’s paying off her credit cards, completing her education and trying to save to buy a home.

“It’s a great idea to pay off high-cost debt with low-cost debt,” Wilkman said.

For homeowners, the ideal way to restructure debt is with a mortgage refinancing or a home equity line of credit, experts say. Home mortgage rates, which were in the 8% range two years ago, now can be had for a little more than 6%, said Steven Foster, president of Vista Financial, a North Hollywood-based mortgage brokerage.

Those with sufficient equity in their homes can boost the amount of their mortgage to take enough cash out of the deal to pay off personal and car loans and credit cards, he said. That can cut required monthly payments and lock in a tax-deductible fixed interest rate.

Those who haven’t built up at least 25% equity in their homes may be better served by a home equity line of credit, Foster said.

Home equity credit lines often cost little or nothing to set up and can be used to tap more home equity.

The interest rate on a home equity line of credit usually is variable and tied directly to the prime rate. Good credit risks with lots of home equity can get a loan at the prime rate -- that’s 4.25% today -- while those with less equity or less pristine credit could pay as much as prime plus 4 percentage points, Foster said.

Home equity loans of as much as $100,000 also are tax-deductible, making them exceptionally inexpensive at today’s rates. But beware, Foster said. The prime rate can rise as rapidly as it falls. If interest rates rise rapidly, the cost of a home equity line can soar.

“If you know it’s going to be several years before you can pay off the debt, move as much of it as you can to a fixed-rate loan so you have more interest rate stability,” Foster suggested.

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Paying vs. Spending

Unfortunately, those who don’t own homes have far fewer options, Wilkman said.

Consumers may be able to refinance a late-model car at a lower rate, but credit card rates are no bargain. For these consumers, the best answer is Jackson’s: Stop spending and start paying off the bills.

“It’s hard to resist the siren call of low-rate financing,” said Keith Gumbinger, a financial analyst with the rate-tracking firm HSH Associates in Butler, N.J. “But if you’re not careful, cheap financing can put you in a very uncomfortable circumstance down the road.”

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(BEGIN TEXT OF INFOBOX)

Costly credit

Borrowers who take out variable-rate loans could be in for a shock if rates start to rise. Here are the monthly payments and total cost for a 10-year, $50,000 home equity line of credit at various interest rates.

*--* Interest rate Monthly payment Total cost 4.25% $512.19 $61,463 4.75 $524.24 $62,909 5.25 $536.46 $64,375 5.75 $548.85 $65,862 6.25 $561.40 $67,368 6.75 $574.12 $68,894 7.25 $587.01 $70,441 7.75 $600.05 $72,006 8.25 $613.26 $73,592

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Source: Times research

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Times staff writer Kathy M. Kristof regrets that she cannot respond individually to letters or phone calls. Write to Personal Finance, Business Section, Los Angeles Times, 202 W. 1st St., Los Angeles, CA 90012, or e-mail kathy.kristof@latimes.com. For past Personal Finance columns visit The Times’ Web site at www.latimes.com/perfin.