Consolidate Debt To Negate Rising Rates
Kevin Graham4-minute read
October 14, 2022
If you’ve been to the grocery store or the gas pump lately, you know that prices are rising at an incredibly fast clip. In order to combat the possibility of hyperinflation, the Federal Reserve has begun raising the federal funds rate.
We’ll go over the effects of this on consumers looking for loans or credit. Then we’ll take a look at one way to combat rising interest rates on your existing debt. But before we jump too far ahead, let’s start at the beginning.
What Is The Federal Funds Rate?
It can be easy to think of interest rates as only impacting consumers. However, financial institutions often borrow from each other to fund their day-to-day operations. This borrowing is regulated by the Federal Reserve through the federal funds rate or fed funds rate.
The fed funds rate is the amount of interest that banks charge when they borrow from each other overnight. When this rate goes up, it becomes more expensive for banks to borrow money from each other. The current range for the federal funds rate is 0.25% – 0.5%. This cost is passed through to consumers starting with the bank’s prime rate.
What Is The Prime Rate?
A bank’s prime rate is the rate they give their best customers. You can think of these as well-established corporate clients who they judge to be least likely to default on their loan obligations.
When banks set the prime rate they want to charge, it’s typically calculated by adding a margin to the federal funds rate. If Main Street Bank adds a 2% margin to the federal funds rate, the current prime rate would be 2.5%.
How The Federal Funds Rate Impacts Consumer Interest Rates
Although the average consumer doesn’t get the prime rate, other rates offered by lenders are usually built on the prime rate plus a margin. Because the prime rate is itself derived from the federal funds rate, the federal funds rate is the benchmark for many consumer interest rates.
When the Fed raises rates, one of the first things consumers will notice is the impact on their credit card rates. Because credit cards are short-term balances that change from month to month, these are the most sensitive to changes in the federal funds rate. In fact, if you look in your credit card contract, it often says that your credit card rate is the prime rate according to some source added to a margin.
Mortgage rates work a little differently because they are based on the yields of mortgage-backed securities (MBS) sold to investors in the bond market. The federal funds rate and mortgage rates tend to follow in the same general direction because if interest rates in general are rising, investors want to see a higher rate of return on their investment. But it’s not an immediate one-to-one correlation.
It’s also important to note that even when rates are going up, mortgages tend to be at the lower end of the spectrum. The reasoning here is that if people are going to make any payment, they tend to make their house payment first. Therefore, MBS is considered one of the least risky investment vehicles for investors.
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Using Your Home Equity To Consolidate Debt
As we talked about earlier, the interest rate on credit cards is whatever the prime rate is plus a margin added by the bank. However, it’s important to note that the margin added by your credit card company could be 15% or 20% depending on your qualifications. While it’s the case that credit card rates are high all the time compared to others, the situation really comes into focus when rates are on the rise.
As rates go up, even if you get a mortgage rate that’s 6%, that’s still preferable to paying 22% interest on a credit card carrying a balance. Let’s run through a quick example.
Let’s say you’re paying 22% interest on $20,000 worth of credit card debt. If you make the minimum payment (for the purposes of this example, the existing interest, +1% of the loan balance), you wind up paying $36,026.45 in interest over time. The minimum monthly payment is $566.67.
Now let’s say you can get an interest rate of 6% on a 30-year loan. The interest you pay on the $20,000 being added to your balance is only $23,167.64. Let’s say you start with the balance of $120,000 on a 30-year loan. Taking cash out and increasing your balance to $140,000 only adds about $120 per month to your payment and saves you nearly $13,000 in interest compared to slowly paying down your credit card balance.
Moreover, paying off your credit card balance lowers your debt-to-income ratio (DTI). This is a key determinant of the kind of monthly payment you can afford when trying to qualify for any kind of financing. Eliminating credit card debt allows you to put yourself in a better financial position moving forward.
Every situation is different, but in general, homeowners are in a great position to tap their equity. According to data from the fourth quarter of 2021 supplied by CoreLogic, home equity rose 29.3% year-over-year to settle at $3.2 trillion.
The Bottom Line
Interest rates may be on the rise, but not every rate is impacted equally. Where consumers are likely to feel the greatest impact of the movements by the Federal Reserve to increase the federal funds rate is on their credit card statements.
In addition to having high rates in general, credit card interest rates are directly correlated with the federal funds rate. Using your home equity to consolidate high-interest credit card debt can allow you to save on interest and lower your DTI, improving your overall financial picture for the future.
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