Here’s Why You’re Going to Pay More to Borrow Money

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Unless you’re into monetary policy, you could be forgiven for mostly overlooking all the discussion about the Federal Reserve’s “taper,” the term given to what will inevitably be a drawn-out process of scaling back the expanded bond-buying initiatives it’s undertaken in the wake of the financial crisis. But although it’s rather dry-sounding stuff, if you have a credit card balance, home-equity loan or other type of loan with an adjustable rate, you need to pay attention, because the takeaway is pretty simple and pretty important: You’re going to pay more. 

The Federal Funds rate is the rate banks charge each other to lend money; the prime rate is 3% above that. Today’s prime rate is 3.25% — where it’s been since 2008, points out Greg McBride, senior financial analyst at Bankrate.com. But while rates won’t zoom up overnight, higher interest rates are coming, and some experts worry American borrowers are unprepared for the ramifications.

“Higher rates are in the cards; the question is how high and how soon,” David Ader, head of U.S. government-bond strategy at CRT Capital Group LLC, tells Bloomberg. He’s talking about government bonds, but the principle holds true for interest rates consumers pay to borrow money, too.

While no one can predict exactly how and when rates will move, “What I do know, however, about the direction of interest rates at this time concerns me,” says Mitchell D. Weiss, financial services expert and University of Hartford adjunct finance professor.

Weiss says homeowners could be blindsided by a jump in rates. Although adjustable mortgages aren’t nearly as common as they were in the mid 2000s, many American homeowners still have second mortgages with adjustable rates.

“This worry is compounded by concerns about the value of the underlying collateral,” Weiss says. Not only are many homeowners in some parts of the country still underwater, but it’s much harder today than it was seven or eight years ago to qualify for any kind of loan. Over the next few years, Weiss says, “The worry has to do with interest rates that are expected to increase… and the impact that will have on post-collapse household budgets.”

Even as rates creep up, Weiss says, consumers might not see the writing on the wall and might continue borrowing at risky variable rates.

Aside from home loans, credit card interest rates are where most Americans will notice rising rates most immediately, thanks to banks’ clever use of a legal loophole. When the CARD Act of 2009 took effect, it said credit card companies couldn’t hike rates on existing balances in most cases as long as the cardholder’s account was in good standing. The exclusion for this was for variable-rate cards tied to the prime rate.

You can predict what happened next: Banks switched customers en masse from fixed rates (although the term “fixed rate” was kind of meaningless because issuers could hike rates at any time for any reason prior to the CARD Act’s implementation) to variable rates pegged to the prime rate. When the prime rate goes up, so does the APR paid by the cardholder, even on existing balances and even if they close out the account.

“The credit card industry is very sensitive to rate tapering by the Federal Reserve,” says Brian Riley, senior research director at CEB TowerGroup.

Let’s say someone has a credit card today with a 24.99% variable APR tied to the prime rate. While that’s on the high side for people with good credit, it’s not out of the ordinary for people with blemished credit or for accountholders of many retail credit cards.

Riley says the increase will probably be moderate at first. “Within a year, if the prime goes up 150 basis points, I would think that’s a lot,” he says. (100 basis points is the same as one percentage point. In other words, a 150 basis point increase in the prime rate would bring it up to 4.75%.)

“American households should be concerned if prime interest moves towards more standard levels of 7%,” Riley says. “That’s been generally the sweet spot when the economy’s in good shape.” This means the average indebted American household will have to shell out close to $400 a month just on interest.

When the prime rate moves, “It tends to show up in variable credit card rates in the ensuing 30 days,” McBride says. Although the average credit card debt held by American households who revolve a balance has fallen from $17,630 in March 2010 to $15,279 today, a month is still very little warning that your monthly bill is going up, especially for people who are just getting by making the minimum payment.

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