On this day (July 27th) back in 1940, the animated icon Bugs Bunny made his official debut in Tex Avery’s film A Wild Hare. Known for his nonchalant carrot-chewing and catchphrase “Eh … What’s up, Doc?” the clever cartoon is characterized as capable of outsmarting anyone who antagonizes him. He even has a star on the Hollywood Walk of Fame.
Much like how Bugs outsmarts his foes, taking note of variable interest rates on outstanding debt can help individuals outsmart the impact rising interest rates may have on their finances. The Federal Reserve has been raising its benchmark federal funds rate, which is the rate banks use to lend funds to each other overnight within the Federal Reserve system. While the Fed does not directly control consumer interest rates, changes to the federal funds rate often affect consumer borrowing costs.
Forms of consumer credit that charge variable interest rates are especially vulnerable, including adjustable rate mortgages (ARMs), most credit cards and certain private student loans. Variable interest rates are often tied to an index, such as the U.S. prime rate or the London Interbank Offered Rate (LIBOR), which typically goes up when the federal funds rate increases. Although nothing is certain, the Fed expects to raise the federal funds rate by small increments over the next several years.
Adjustable Rate Mortgages (ARMs)
For those with an ARM, interest rates and monthly payments may change at certain intervals. For example, with a 5/1 ARM, the initial interest rate is fixed for five years but can then adjust every year if the underlying index goes up or down. Loan documents will specify which index the ARM tracks, the date the interest rate and payment may adjust and the permissible rate change from one year to the next (e.g., if rates cannot increase or decrease more than 2% annually). ARM rates may have caps that limit the interest rate to a certain minimum or maximum. Refinancing into a fixed-rate mortgage could be an option if there is a concern about steadily climbing interest rates, but this may not be cost effective if an individual plans to sell his home before the interest rate adjusts.
It’s generally a good idea to keep that debt in check. However, it is especially important when interest rates are trending upward. Many credit cards have variable annual percentage rates (APRs) that are tied to an index (typically the prime rate). When the prime rate goes up, the card's APR will also increase.
Credit card issuers must give written notice at least 45 days in advance of any rate change, so there is a little time to reduce or pay off any balances. For those who cannot pay off their credit card debt quickly, there may be alternatives. One option is to transfer balances to a card that offers a 0% promotional rate for a set period of time. However, watch out for transaction fees, and find out what APR applies after the promotional rate term expires in case a balance remains.
Variable Rate Student Loans
Student loans are another area to watch out for. While interest rates on federal student loans are always fixed, rising federal funds rate could increase monthly payments for variable-rate student loans from private lenders. Variable student loan interest rates are generally pegged to the prime rate or LIBOR. Since repayment occurs over a number of years, multiple rate hikes for variable rate loans could significantly affect the amount needed repaid. It’s smart to review loan documents to find out how the interest rate is calculated, how often the payment might adjust and whether the interest rate is capped.
Since interest rates are generally lower for variable rate loans, an increased monthly payment may be still be manageable. However, if the repayment term is long and a more “locked in” payment is preferred, consider the costs and benefits of refinancing into a fixed rate loan.
Sometimes asking a simple, yet deceptively smart, question like “Eh … what’s up?” regarding debt can make a difference. Know which obligations have variable rates and what the implications may be as the Fed likely continues bumping up the federal funds rate in the coming years.