You may never have considered having a home equity loan. But, if you carry a lot of debt that charges a variable interest rate – and that includes virtually all credit cards and store cards, and many personal loans, home equity lines of credit (HELOCs), auto loans, student loans and others – you might want to give it some thought now.
Higher Rates Ahead
That's because many Americans are likely to be hit hard when (we're probably past "if") the Federal Reserve begins to hike its benchmark ("Federal Funds") interest rate. It chose not to do so in September 2016, but signaled it would likely implement the next increase later that year – with more to come in 2017 and beyond.
Now, it's true the Fed's promised each increase is going to be small, and many expect rises to be in 25-basis point increments. A basis point is just one-hundredth of 1 percent, so on average we'd be looking, for example, at a credit card rate that's currently 17.5 percent inching up to 17.75 percent. That sounds like nothing, but credit bureau TransUnion reckons even that tiny hike will leave 9.3 million consumers struggling to cope.
And that increase, which most now expect to happen in December 2016, is likely to be the first of many. In September 2016, the Fed's benchmark rate stood at 0.5 percent, but it's expected to hit 1.9 percent by the end of 2018, and some are forecasting it will stand at 2.25 percent in 2020. If a 25-basis point hike inflicts real pain on more than 9 million consumers, how many would suffer from a 175-basis point increase, even if that is drip fed over four years?
Higher Rates Normal
An additional danger is posed by our expectations. The Fed held its rate steady at 0.25 percent for five years, raising it in December 2015 to 0.5 percent. That means we've grown used to variable-rate credit feeling the same as fixed-rate borrowing, and many of us have forgotten the real strain unexpected rate hikes can inflict on our finances.
And we've forgotten what normal is. One thing's for sure, it's not the sort of cheap borrowing we've enjoyed for much of the last decade. At the turn of the century (only 16 years ago), that Federal Funds rate, which is currently 0.5 percent, was 6 percent, and it climbed higher in 2001. It then fell, but was back up above 5.0 percent around 2006-08. Go back to 1985, and it was over 11 percent.
Higher Rates Hurt
For most readers, it's not time to panic – yet. To start with, not everyone is exposed to variable rate debt. And most of those who are (68 percent of Americans who have any form of credit at all) won't be intolerably impacted by a single 25-basis point rise. That TransUnion report cited above, which was published in September 2016, suggests that, of those consumers who will be affected at all:
- 82 percent will see their monthly payments increase by less than $10
- 99 percent will experience payment increases of less than $50 a month
Even so, TransUnion concludes, "9.3 million consumers do not appear to have the capacity to absorb a 25-basis point rise in interest rates." And, of course, many who can shrug off a single hike, will find it increasingly hard to cope with a second, third and fourth – let alone the seven many expect over the next four years.
Home Equity Loans a Possible Solution
If you're a homeowner with a reasonable credit score (check yours now for free) and some equity (your home's current market value is higher than your current mortgage balance), you may be able to escape the impact of future rate rises by refinancing all your variable-rate debt within a fixed-rate home equity loan. Providing you don't run up further debts, you'd then be able to sit back and watch future Fed hikes with complete equanimity.
This would bring a number of benefits: most importantly, it would almost certainly significantly cut your monthly debt-related outgoings. Home equity loans are effectively second mortgages, and are thus among the lowest rate and least expensive forms of borrowing around.
However, like all borrowing, home equity loans come with downsides as well as advantages, so you should think through the implications before signing up for one. In particular, bear in mind you're refinancing mostly "unsecured debts" (ones that aren't tied to a particular asset that the lender can take if you fall behind with payments) and will be putting your home on the line if things go wrong. Find out more by reading The Pros and Cons of Home Equity Loans.
Mortgages Another Factor
Of course, if you're already considering a mortgage refinance to take advantage of today's ultra-low mortgage rates, you could instead undertake a cash-out refinancing, which may allow you to pay down in one fell swoop all your variable-rate debt. Although that's likely to dramatically reduce your overall monthly payments on debt, you need to recognize you'll be paying down what should be short-term debt over maybe 30 years, which may or may not bother you. Again, you should think through the implications of such a refinance, but it might be a better choice than a home equity loan, with even lower rates and outgoings.
If you've been reading the above and have an adjustable-rate mortgage (ARM), you may have been wondering how future Fed rate hikes might affect you. And you'd be right to be worried: Your monthly payments are likely to rise in line with those increases. So now – while mortgage rates remain very low and before the Fed acts – could be an ideal time to refinance to a fixed-rate mortgage. Give it some thought, and start by reading When Should You Refinance an ARM into a Fixed Mortgage?