Interest Rates A-Comin’. The Ins and Outs of Debt.

The level and trend of interest rates impacts each of us differently. Generally, lower rates benefit us by stimulating the economy, equity and real estate investments. Borrowers are also big fans of lower rates. You can reduce your payments and possibly shorten your loan payoff date by refinancing. Or if you’re making a major purchase – car, home or business acquisition – you might be able to borrow more. However, re-read the prior sentence and reconsider before taking on new debt.

Here are four areas to consider before taking on new debt:

All rates aren’t equal

The news about the Feds raising or lowering interest rates may be misunderstood. Federal Reserve officials determine the federal funds rate – which is only the overnight interest rate that banks charge each other when doing inter-bank lending, in order to meet the required reserve levels. Changes impact short-term and variable (adjustable) interest rates – e.g. Certificate of Deposit (CD) rates, lines of credit and even some car loans. However, they don’t set mortgage rates that you’d be interested in for your home or an office building, for example. Those rates are determined largely on the secondary market where mortgages are bought and sold, and factors related to you – credit scores, home mortgages, down payments or equity, and loan terms. For example, the federal funds and prime rate for the year to date remain unchanged; however, the 10-year treasury yield has dropped about 0.7 percent.

Could housing be more affordable?

An important part of affordability is the determination of house-buying power: how much you can buy based on changes in household income and fixed 30-year mortgage rates. Lower interest rates should increase buying power. Using some national figures – the average 2018 household income of $65,400, five percent down payment, and a 4.5 percent 30-year rate – the consumer house-buying power was $372,060. Now, assuming a 0.5 percent mortgage rate decrease, house-buying power jumps by more than $20,000 or 5.8 percent. However, in hot real estate markets, that gain may be lost to escalating home prices.

Budget savings from refinancing

Mortgage applications are up about 15 percent from the prior year according to the Mortgage Bankers Association. This has been driven by refinances which are up about 31 percent annually as homeowners have taken advantage of lower interest rates. Here’s an example. Assume you have a 30-year mortgage of $250,000 and principal and interest payments of $1,419 a month. If rates were one percent lower and you refinanced, your payment would drop to about $1,266 and save you about 15 percent in interest payments over the life of the loan. Alternatively, you could refinance and maintain the same monthly payment and payoff the loan six years sooner, saving you about 39 percent in interest expense.

Be smart with cash outs

Real estate owned by U.S. households totals about $25 trillion. Net homeowner equity totals about $15 trillion after $10 trillion of mortgage debt. Home equity is an idle asset and available only if you sell or borrow against it. People can tap into home equity by taking a cash-out refinance. Freddie Mac estimated that the average “cash-out” borrowers increased their loan balance by five percent and represented 83 percent of all conventional refinances (Freddie Mac’s Quarterly Refinance Statistics, Fourth Quarter 2018). Cash-outs in the fourth quarter totaled $14.8 billion, down from $20.4 billion a year earlier, and significantly down from the peak quarterly cash-out of $104.8 billion in the second quarter of 2006.

This resembles a little déjà vu or scenes from the movie “Groundhog Day,” where some used their home equity as a personal ATM and the Great Recession hit. There are absolutely prudent cases or emergency needs for cash-outs where you need to finance something instead of using more expensive credit cards. But why would you turn a new ski boat that you’ll resell in 5 years, kitchen appliances, or wedding or college expenses into a 30-year debt? Instead, how can you be a savvy borrower and lower your interest expense over the long term and not risk your long-term security?

Perhaps design an aggressive debt repayment schedule or help your kid find a less expensive school that won’t put you/him/her in debt. An ancient proverb goes: “There are four things every person has more of than they know: sins, debt, years and foes.” Debt can be a menace, but it also can be a tool.

Secure your future wisely.

This article can also be viewed at the Reno Gazette Journal.

About Brian Loy

Brian Loy writes insightful and inspiring articles about the ever-changing world of personal finance and the global trends that affect the risk and return on investments and shape the financial- and retirement-planning process.
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