For the past five years, interest rates have been lower than they have been in decades, with the benchmark federal funds rate bottoming out at a mere 1% and the prime rate hovering at just 4% for much of 2003 and 2004. As a result, many credit cards have been offering much lower interest rates to their customers. In fact, many consumers have grown accustomed to these lower rates. Many of these consumers are in for a rude awakening.
The problem is that most credit cards have variable interest rates. Often these rates are tied to the prime rate, so that for every point the prime rate rises, the credit card interest goes up a point as well. This can lead to sharp increases in monthly payments for most credit card holders when the prime rate is on the rise.
Since late 2004, the Fed has been continually raising the benchmark federal funds rate. As of June, 2006, that rate has risen to 5.25%, and it is expected to be raised at least another ¼ point when the Fed meets again in August. That would mean that anyone with a credit card tied to the prime rate would have seen a 4 ½% increase in their interest rate over the span of some 18 months. This escalation in interest rates can have a devastating effect on a consumer’s monthly budget.
For example, take a consumer carrying who is $9000 in credit card debt, which, incidentally, is the amount of such debt carried by the average American consumer. Let’s assume this consumer had been enjoying a relatively low 9% interest rate on their credit card purchases from 2002-2005, when the prime rate was around 4%. By August of 2006, this interest rate would have risen to 13.5%, a very significant increase indeed.
That 4.5% increase in this customer’s interest rate could lead to an increase of $405 a month or more in his or her monthly credit card payment, and that is assuming no new charges are made. An additional $405 is quite a monthly hit. In fact, many consumers are simply unable to handle such an increase. So what can be done to avert financial disaster?
One possibility would be to move the balance of the debt to a fixed rate loan. This could include taking out a home equity loan or even a personal line of credit. With regards to home equity loans, it is important to take into consideration that, while such loans often offer a significantly lower interest rate than credit cards, this reduction comes because such loans are secured. You are, in effect, putting your home up as collateral. Credit cards are usually unsecured loans. If you miss a payment, your personal property cannot automatically be repossessed.
Personal lines of credit are another potential means of consolidating debts under a fixed interest rate. Often, consolidation loans are not secured, much like credit cards. However, because of this they tend to have higher interest rates than home equity loans. Nonetheless, for some consumers, consolidating higher interest credit card debt with personal line of credit can be a viable means of reducing interest and lowering monthly payments. It is important to read the fine print with such a loan. Make sure the loan truly has a fixed rate. Whether or not this method will work for you depends on several factors, including your credit score. If your score is on the low side, then the interest rate and other terms of a personal loan might not be acceptable.
So what if neither a home equity loan nor a personal line of credit is the answer for you? The first thing to do is simple: stop spending. You must stop adding new credit card debt immediately and start paying down your current principal by increasing your monthly payments as much as you can. Think of ways you can cut back on your spending. For instance, go to one less movie a month and apply the twenty bucks to your credit card. Or you could make your morning coffee at home instead of buying it at at your favorite coffee house, then take the $3.50 a day you save and use it to pay down your credit card bill. Do whatever it takes.
With inflation threatening to increase, the Fed might well be forced to increase rates even further. So, pay off as much of your debt as you can now, before the variable interest rates come back to bite you in the future.
Scott Miller is editor of DebtConquest.com, a free guide to credit card debt reduction , which includes sections on debt consolidation and home refinancing .