|
|
|
|
Extra
When will it start to hurt, Dr. Greenspan?
The Fed may be stepping up the pace of interest-rate increases to ward off inflation, but home loans, credit cards and car loans will feel the effects quite differently.
By Bankrate.com
When the Fed increases interest rates, it doesn't ripple evenly through the economy. Different interest rate-related products will behave in different ways leading up to, and in response to, a Fed rate increase. Below is a look at how soon each product category will reflect the Fed's March 22 rate increase.
Fixed-rate mortgages: Fixed mortgage rates are closely tied to long-term government bond yields and are not directly tied to Fed interest rate moves. Case in point: The average 30-year fixed-rate mortgage dropped from 6.3% on June 30, when the Fed first increased interest rates, to 5.59% on Feb. 9. The decline in long-term bond yields and fixed mortgage rates was perplexing to many, including Alan Greenspan. In congressional testimony on Feb. 16, Greenspan referred to the decline as a "conundrum" and said it may be "a short-term aberration." This delivered the message that long-term bond yields and mortgage rates were too low given the prospects for continued Fed interest rate hikes. In the one month since, the average 30-year fixed-rate mortgage has climbed to 6%. There are other factors that could push bond yields and mortgage rates still higher, such as a surge in inflation. Also, continued declines in the value of the U.S. dollar could cause foreign investors to lose their appetite for dollar-denominated U.S. securities. Any mass exodus from the bond market by these investors would push interest rates significantly higher.
Adjustable-rate mortgages: Rates on ARMs are primarily tied to short-term indexes, such as LIBOR, the one-year Treasury or the 11th District Cost of Funds. As the Fed boosts short-term interest rates, ARMs are far more sensitive after the fact than fixed-rate mortgages. For borrowers facing rate adjustments, the relevant comparison is the current level of the underlying index plus the loan's margin, versus the initial start rate. As short-term interest rates rise, this contrast will expand and lead to some unpleasant rate adjustments for borrowers that took out ARMs at record-low interest rates. Consider a one-year ARM taken out in March 2004 when the prevailing national average was 3.42%. Now facing the first rate adjustment, with the one-year Treasury yield currently 3.3% and a loan margin of 2.5%, the rate could jump to 5.8%. While many ARMs have a periodic cap that keeps the rate from rising more than 2 percentage points at one adjustment, some ARMs permit the first rate adjustment to be as high as 5 percentage points. Even with a 2-percentage-point cap, for a buyer who borrowed $200,000 one year ago, the monthly payment increases by $230. The borrower is also likely to face another increase next year. By contrast, a borrower taking out a 5/1 ARM at the current average rate of 5.41% is insulated from any rate increases for the first five years.
Home equity loans: Rates for home equity loans are fixed, and any changes in rates do not impact existing borrowers. Small, short-term home equity loans are often tied to the prime rate, which moves in close concert with Fed interest rate hikes. For these loans, locking in rates sooner, rather than later, will insulate borrowers from higher rates. But most borrowers taking home equity loans are borrowing a significant amount of money and repaying it over a 10- or 15-year period. Rates on these products will track more closely to long-term interest rates, much like fixed-rate mortgages. Since Bankrate.com switched to a loan amount of $30,000 in the weekly survey on July 21, 2004, the average home equity loan rate hasn't increased from 6.99%, fluctuating between 6.86% and 6.99% in the interim. But between another Fed interest rate hike and the recent rise in long-term interest rates, home equity loans of all terms seem poised to see higher rates in the coming months. Locking in rates now would avoid future increases.
Home equity lines of credit (HELOCs): Since Bankrate.com switched to a $30,000 line of credit in the weekly survey on July 21, 2004, the average HELOC rate has increased from 4.71% to 5.91%. Variable-rate HELOCs will continue to increase for both existing and new borrowers alike. Lenders will be quick to reprice HELOCs on the heels of the Fed's rate hike, with most borrowers noticing the higher rates within one or two statement cycles. HELOC rates will continue to closely mimic moves in the prime rate. The impact on monthly payments will be modest for borrowers in the early years of a HELOC where the required payment consists only of interest. Be wary, however, of accumulating a large balance in the interest-only years that will have to be paid off at potentially higher interest rates in the repayment period.
Auto loans: Rates for new- and used-car loans are fixed-rate loans and will not impact existing borrowers. Much of the impact of an interest rate hike is seen before a Fed move as car loans are increasingly responding to yields on Treasury securities instead of being pegged to the prime rate. This is because lenders are packaging auto loans together and selling them into the secondary market, as is often done with mortgages. The good news for borrowers is that auto loan rates aren't responding much to movements in either the prime rate or yields on Treasury securities. In the past year, the average three-year Treasury yield has soared from 1.92% to nearly 4%, while the prime rate has climbed from 4% to 5.5%. But auto loan rates have increased much more modestly. The average four-year new car loan rate is currently 7.61%, up from 7.22% one year ago. The average three-year used-car loan rate has increased from 8.19% to 8.39% in the same period of time.
Credit cards: Variable-rate credit cards will move in direct response to Fed interest rate action as most are tied to the prime rate. Some cards were immune from the initial interest rate hikes because they had previously hit floor rates, but with the repeated interest rate increases they are now rising. There can be up to a three-month lag between an interest rate hike and a credit card repricing. However, rates are quicker to rise than to fall. Consider the average platinum variable rate that increased from 10.76% to 12.73% since the Fed began boosting interest rates in June. Cardholders with less-than-perfect credit can expect to pay higher rates, and will also see rates continue to climb. Even fixed-rate credit cards are potentially sensitive to rising rates, as issuers can change the terms with as little as 15 days' notice. This can mean one of two things. The issuer could reprice the card to a higher fixed rate, or the issuer could change the card to a variable rate card that would respond much more quickly to subsequent interest rate increases. Issuers tend to reprice fixed-rate cards in response to a series of interest rate hikes rather than after each individual change. Although the average fixed-rate card has increased only slightly since June, from 12.79% to 12.93%, some issuers have switched fixed-rate cards to a variable-rate. Fixed-rate credit cards are not a haven from higher rates.
But good news for savers
Certificates of deposit: Yields on certificates of deposit move with yields on Treasury securities of a similar maturity, as they compete for the same investment dollars. Longer-term CDs, such as the five-year CD, typically move further in advance than a short-term CD, such as the three-month CD. Yields on three-month and six-month CDs increase in closer concert with actual Fed moves, and have been increasing steadily since the first rate hike on June 30. The average three-month and six-month CD yields are now 1.69% and 2.05%, up from 0.89% and 1.08%, respectively, on June 30. Just as fixed-mortgage rates move independently of the Fed's handling of short-term interest rates, so too do yields on many CDs. After a sharp increase between March and July, yields on five-year CDs fell from 3.62% to as low as 3.48% in November due to the uncertain economic climate. More recently, five-year CD yields have rebounded to 3.67% as yields on longer-maturity Treasury securities have begun to climb. The fortunes of longer-maturity CDs, such as the five-year CD, will move according to long-term interest rates. Investors should keep an eye on inflation and continue to favor shorter maturities that facilitate reinvesting into longer maturities as yields improve.
Money market accounts (MMAs): Yields on money market accounts are closely tied to what the Fed does with short-term interest rates. But not all banks will be eager to reward depositors with better returns. The largest banks that dominate in many markets around the country have been very stingy about increasing money market payouts. As a result, the average money market account yield for the minimum required deposit has shown scant improvement since June, rising from 0.45% to 0.57%. Money market accounts requiring higher initial deposits have fared only slightly better, with the average yield on a $10,000 minimum investment rising from 0.64% to 0.82% since June. For deposits of $100,000, the average yield of 1.27% is up from 0.91% in June. All remain well below the current rate of inflation of 2.9%. Even a yield that trails inflation now has the prospect of rising above inflation as further Fed moves push interest rates higher and work to contain inflation.
Money market mutual funds (MMMFs): Yields on money market funds have been increasing steadily since the June 30 Fed rate hike and will continue to do so on the heels of a seventh rate hike on March 22. It may take nearly three months before a rate hike is completely reflected in money fund yields as short-term investments within the fund mature and are then reinvested at the now higher rates. Even though money fund yields have been increasing since the Fed started boosting short-term rates in June, the best-yielding money market mutual funds still fall far short of the highest-yielding bank money market deposit accounts.
|
|
|
|
