June 1, 2023How to Manage Debt When Interest Rates are Rising
However, it’s an entirely different story when loan rates are also increasing – especially if the interest rates on your loans are variable. Sudden jumps can derail your budget instantly if you’re not prepared.
Managing existing debt and finding ways to preserve cash in a rising rate environment is crucial. The best place to start is by understanding the different types of loan rates and how the economy can impact your outstanding balances.
Types of Interest Rates:
Many people are surprised to learn there are two types of interest rates for loans: fixed and variable. Both come with their own pros and cons, but one presents greater financial risk during periods of rising rates.
Fixed Rates: When your loan rate is fixed, the interest rate will not change for the life of your loan. For example, most car loans have fixed rates. No matter what the economy is doing, your car payment and rate will be the same, whether it’s your first payment or your 30th.
- Advantages: Fixed rates are ideal if you don’t like surprises when it comes to your money. If the economy causes interest rates to rise, it will not impact your loan.
- Disadvantages: A common drawback of fixed rates is that if interest rates decline, you could be stuck paying a higher rate. If this is the case, you can always refinance your loan to take advantage of lower rates.
Variable Rates: Variable loan rates are more complex. These rates can fluctuate over time based on certain factors – most commonly because of the economy. For example, assume your variable-rate credit card currently charges 9% APR. If the Prime Rate increases by 0.5%, your new credit card rate will likely become 9.5% APR.
While PEFCU has fixed rates on most of our products, other lenders may use variable rates to protect themselves from market fluctuations over the long term. You’ll commonly see variable rates with ongoing loans, such as credit cards, personal lines of credit, or home equity lines of credit. Some mortgages will also fall into this category.
- Advantages: Because the rates will fluctuate with the economy if rates decline, your loan rate will likely follow suit. You don’t have to worry about refinancing your loan – you will benefit automatically. Also, many adjustable-rate mortgages (ARMs) will offer very low introductory rates for several years before adjustments can occur. This is an excellent scenario if you don’t plan to live in the home long-term.
- Disadvantages: Borrowers with variable-rate loans risk paying more as interest rates rise. The sudden jumps in rates (and loan payments) can unexpectedly throw off your budget and cause financial challenges.
Luckily, many variable-rate loans limit how much a rate can adjust during a set period.
Managing Rising Loan Rates:
Having variable-rate loans in a rising-rate environment isn’t the end of the world. While it’s never enjoyable to have loan payments suddenly increase, long-term, you could still benefit significantly with variable rates. However, if your goal is to save more in the short term and avoid paying excess interest on your current debt, the following steps will come in handy.
- List All Loans: Make a list of all your current loans and credit cards. Review your statements to determine if the loans include fixed or variable rates. If unsure, a quick call to your lender will help you find out.
- Detail Loan Amounts: Once you identify all your outstanding loans and credit cards, you’ll want to determine which loans have the greatest impact on your finances. Add current balances, interest rates, and monthly payments to your list.
- Focus on Variable-Rate Loans: Next, begin reviewing your existing variable-rate loans. Explore today’s current fixed-rate alternatives. Does it make sense to refinance your loan into a fixed-rate option? Even if fixed-rate alternatives are a bit higher, it might be worthwhile if rates are projected to rise well into the future. Consider the following example:
Imagine you have a personal line of credit with a variable rate of 8% APR. You could switch to a fixed-rate personal loan instead that offers rates at 9% APR. Immediately, the interest rate is 1% APR higher. However, if rates continue to rise, after another year or two, the rates on the variable-rate loan might increase up to 11% APR or higher. Acting today would prevent more costly interest charges down the road.
- Craft a Strategy: Refinancing your variable-rate loan into a fixed-rate alternative isn’t always possible or ideal. For example, most credit cards today offer variable rates. To offset higher interest rates, it’s wise to work on a plan to eliminate the debt quicker – ideally before the next rate adjustment takes place.
Start by focusing on the credit card (or other debt) with the highest interest rate. For credit cards, pay as much as you can afford monthly until the debt is eliminated. Then, move to the next highest, variable-rate card.
For non-credit card debt, such as a personal line of credit, consider the following payment strategies:
- Bi-Weekly Payments: Switching to bi-weekly payments will require you to make half your regular payment every other week. Since there are 26 bi-weekly payments in a year, you end up making one extra full payment per year.
- Make an Extra Payment: If your loan allows prepayments, consider making one additional payment per year (toward the principal portion of your loan). This tactic will reduce the interest you pay and eliminate your debt quicker.
TIP: Using your tax refund is a great strategy.
- Round Up Your Payments: Consider rounding up your payment to the nearest $50 or $100. If your monthly payment is $215, try to pay $250 or $300 monthly (with the extra going toward your loan’s principal balance).
- Avoid New Debt: When loan rates are increasing, it’s wise to limit taking on new debt or adding to credit cards – unless necessary. Holding off on any major purchases could benefit you if rates shift and suddenly begin to decline.
We’re Here to Help!
While rising interest rates are great for savers, they can also negatively impact borrowers’ wallets. If you currently have loans with variable interest rates, we might be able to help you save money.
Please bring your current loan paperwork to any of our convenient branch locations or schedule an appointment with a member of our lending team by calling 800-226-6673.
Each individual’s financial situation is unique and readers are encouraged to contact PEFCU when seeking financial advice on the products and services discussed. This article is for educational purposes only; the authors assume no legal responsibility for the completeness or accuracy of the contents.