Interest rate hike ahead? Take time now to work out payoff plan, refinance high-interest debt

Lifestyle and Budget Associated Press

It's no longer a matter of if, but when. The interest rate on everything from credit cards to adjustable-rate mortgages could soon be headed higher.

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The Federal Reserve signaled once more on Wednesday that it will likely begin raising its benchmark interest rate later this year. The rate has been near zero since December 2008 as part of the central bank's strategy to stimulate job growth.

Keeping the federal funds rate so low has lowered the expenses of consumers with variable-interest rate debt, such as credit cards.

After an initial rate hike, the Fed says interest rates would likely remain at very low levels for quite some time. One or two small rate increases would have a negligible impact on borrowing costs.

"Consumers should be mindful of what the potential cumulative effect could be if the Fed raises rates several times over the course of a couple of years," said Greg McBride, Bankrate.com's chief financial analyst.

Here are some steps to consider before interest rates begin climbing:

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— ASSESS YOUR DEBTS

Do you have any variable-interest loans, such as credit cards, an adjustable-rate mortgage or home equity line of credit? These are the types of loans that will be primarily affected by changes in the federal funds rate.

That's because the annual percentage rate, or APR, on these loans is typically a combination of a percentage rate that's determined by the borrower's credit score plus the prime rate.

The prime rate is a benchmark interest rate that tends to follow the trajectory of the federal funds rate. If the Fed funds rate is steadily rising, so will the prime rate, translating into a higher overall interest rate on many consumer loans.

— GAUGE RATE HIKE IMPACT

Many economists anticipate that the Fed will begin rising rates as soon as September. They predict, at most, two increases of 0.25 percent in the Fed's benchmark rate this year.

Going by that forecast, borrowers wouldn't see much in the way of added interest costs. For example, take a $5,000 credit card balance. A 0.50 percent increase would amount to about $2 a month or roughly $24 annually in extra finance charges, said Paul Siegfried, senior vice president and head of TransUnion's card business.

The borrower in this example would also see his or her minimum monthly payment increase as well. That's because it is typically based on a combination of finance charges, which would rise along with the prime rate, plus a percentage of the balance.

"This is not something that has necessarily a big impact on your household budget, because of the payment flexibility, the ability to make minimum payments," McBride said.

— CONSIDER REFINANCING

Although the Fed appears unlikely to raise interest rates quickly, it may be a good time to consider options for refinancing any debt that would be affected.

The prospect of rising interest rates makes balance transfer credit card offers particularly appealing.

Generally, such offers include an introductory period to pay off the balance with no, or a sharply reduced, interest. The period can last for a year or more.

Introductory balances for credit cards were not always at zero percent. That became the norm over the past six or seven years, because the federal funds rate has been so low. Before that, it was common to see card balance transfer offers of 3.9 percent for periods ranging from 12 months to 21 months.

But when the Fed begins raising rates, that will make it less attractive for banks to offer these deals.

"As the costs of funds go up, institutions may not be able to issue such an aggressive or competitive price," Siegfried said. "The question is, where is that point?"

Homeowners may be tempted to access the equity in their home to refinance their debts. That can make sense, especially because mortgage interest payments can be deducted come tax time. But remember there's a trade-off: Shifting unsecured debt onto a loan that's secured by your home.

Getting a fixed-rate personal loan from a bank or from a peer-to-peer lender, where individuals borrow money from a pool of investors, may also be a good option. Rates on those loans can be lower than credit card rates, and they're fixed. Note that they're not immune from rising rates, so if you're going to refinance, it's best to do so before any rate hikes begin to kick in.

— PUSH FOR PAYOFF

A balance transfer or other form of refinancing can lower your interest rate costs or shield you from hikes temporarily. But it's best to see it only as a first step.

Instead of trying to merely lower their interest rate costs, borrowers should make a plan to pay off the debt as soon as possible, said Peter Ashby, a certified financial planner in Roseville, California.

"It makes sense to seek a lower interest rate once a plan is in place to reduce the debt and future spending," he said.