The 5 Best Ways to Plan for Higher Interest Rates

Mortgage interest rates are currently at record lows. However, this won’t last forever. Sooner or later the Federal Reserve is going to raise interest rates and this could have serious effects on the economy of many households. Plan ahead by taking practical steps while interest rates are still low.

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As part of its ongoing stimulus effort, the Federal Reserve has announced its intention of maintaining interest rates at their current artificially low levels. The hackneyed quote “You never know what you have until you lose it” is simply not true. We know what we have; we just never think we’ll lose it. Mortgage interest rates have been extremely low for several years now. This has caused some borrowers to take them for granted. Kind of like when homeowners assumed property prices would continue rising indefinitely. We all know how well that worked out for us.

1. Pay Off Credit Cards

If you have a decent credit rating and have a home loan, you are probably paying much less for your mortgage payments than you would under normal market conditions. This means extra cash in your pocket. On the other hand, interest rates on saving accounts are so low it could actually cost you money – once you adjust for inflation — to put your cash in a savings account.

A much better use of your extra cash is to pay off debts. Make a list of all your personal loans, such as credit cards, car loans and lines of credit. Pay as much as you can toward the loan with the highest interest rate. If you have any outstanding balances on your credit cards, they will probably be your most expensive loans. As of November 2013, the average interest rate on a credit card was 15%. Paying off credit cards has to be the least sexy way of spending your hard-earned cash, but it may help to view it as giving yourself a 15% return on your investment. Good luck finding a mutual fund that guarantees a 15% interest rate — or anything close — on your investment.

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2. Switch to a Fixed-Interest Mortgage Loan

Fixed-interest loans provide homeowners with the peace of mind of knowing exactly what their monthly payments will be for the duration of the mortgage, without worrying about what the Federal Reserve does with interest rates. With interest-rates at such historic lows, there has hardly been a better time to switch to a fixed-interest mortgage.

However, fixed-interest mortgages are generally more expensive than variable interest loans and not all borrowers will meet lenders’ credit and equity requirements. For instance, homeowners who owe more on their mortgage than its market price value – also known as an underwater property – will struggle to find a lender willing to refinance or modify their loan.

3. Overpay Your Mortgage

Another option is to use the extra cash you now have from low-interest payments to pay off the principal on your loan. The principal on a loan is the initial amount you borrow from which interest payments are calculated. Overpaying on your mortgage will allow you to clear your mortgage earlier and reduce the amount of interest you pay. How much money can this save you over time?

To illustrate, if you have a $100,000 mortgage and you have a 4.3% variable rate and you overpay $250 every month for three years, you could reduce your mortgage balance by nearly $10,000. The benefits are even greater if you overpay for long periods of time. So, if you overpaid $250 every month on the same 15-year mortgage for the duration of the mortgage, you would both save $11,979 in interest and pay the mortgage nearly 5 years early.

4. Reduce Your Loan-to-Value Ratio

Granted, analysts estimate that interest rates will probably rise significantly in the next three years, so you may not have the money to overpay your mortgage for long. However, overpaying now will help to reduce your loan-to-value ratio: a key ratio lenders look at when considering loan modifications and mortgage refinancing applications.

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Example: if your property is now valued at $100,000 and you still owe $90,000 on the mortgage; you have a 0.9 or 90% loan-to-value ratio. Although there are no rules set in stone, many lenders use a minimum of 80% loan-to-value ratio when assessing applications.

5. Plan Ahead

Planning ahead for when interest rates rise is just common sense, if you are a homeowner. The best strategy for you will depend on your circumstances. Although paying more on your mortgage installments is an excellent strategy for many borrowers, it’s not for everyone. For instance, if liquidity is a problem for you, avoid investing your cash into overpaying your mortgage. Once you overpay on your home loan, it is very difficult to convert it back into cash in an emergency.

Just paying off debts and trimming off on unnecessary fixed expenses may be enough to prepare for leaner years when higher interest rates will make a larger dent into your family’s budget.

This article was written by staff writer Andrew Latham. His mission is to help fight your evil debt blob and get your personal finances in tip top shape.