Personal Finance > Your Home
Seizing the moment
June 27, 2001: 2:29 p.m. ET

How you can jump on falling interest rates to improve your financial situation
By Bettina Teodoro
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NEW YORK (CNNfn) - As expected, the Federal Reserve cut short-term interest rates Wednesday for the sixth time this year a move many hope will help set the stage for economic recovery.

Lower interest rates, of course, make it cheaper to borrow money. They help boost consumer spending on services and big-ticket items, which fuel the U.S. economy.

But not all lenders follow the central bank's lead. For instance, Fritz Elmendorf, vice-president of the Consumer Bankers Association, said he does not expect auto lenders to reduce the interest rates applied to car loans, because these are not tied directly to the prime rate. The prime rate tends to move in line with rates set by the Federal Reserve. Following the Fed's quarter-point cut Wednesday, major U.S. banks lowered their prime lending rates a quarter-point to 6.75%.

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graphicCNNfn's Valerie Morris takes a closer look at what the Fed's rate cut means for people beyond Wall Street.
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However, Elmendorf said, car loan interest rates already are quite low to begin with, "so the things you could consider [to finance a car] are either getting a loan, or using home-equity credit, or also the industry itself has been promoting subsidized rates and that's likely to continue because of the state of the economy."

Experts also said the Fed's cut will have only a mixed effect on short- and long-term mortgage rates. Frank Nothaft, deputy chief economist at Freddie Mac (FRE: down $0.69 to $67.90, Research, Estimates), said long-term fixed rates, which are pegged to the 10-year Treasury bond, are unlikely to change much.

"They've been hovering at 7 to 7-1/4 percent for the last two months, and it's unlikely they're going to change," he said. "So we would expect them to remain in that range over the course of the summer."

Short-term, adjustable rate mortgages (ARMs), indexed to one-year Treasury yields, likely will drop in response to the Fed. But, Nothaft said, "they generally won't come down as much, because what the Fed controls is the overnight lending rate ... so the effect on a one-year rate will be less than the effect on an overnight rate."

With all this in mind, how can consumers make the most of this low-rate environment?

Tools for saving

Elmendorf said a good place to start is with a home-equity line of credit which uses equity in a home as collateral because the interest rates on these types of loans are tied directly to the prime rate. As such, they will drop correspondingly with the federal funds rate.

If you carry a balance on your credit cards, you might also get a lift from the Fed. Elmendorf said 60 percent of credit cards have variable interest rates that are tied to the prime or some other short-term indicator, so those rates also can be expected to drop.

Elmendorf adds, however, that some credit cards have "a floor set as to how far down they would drop, and some may have reached the floor with the last [rate cut]."

Even with lower interest rates, however, credit cards still boast one of the highest lending rates in the industry, some as high as 22 percent.

Another way to capitalize on the rate cut is to take out a low-interest loan, including a home-equity loan, to cover all outstanding credit card and other high-interest debts. This could have short- and long-term benefits, reducing both the amount of the monthly payment and, if you used the savings from the lower interest payments to pay down your debt further, perhaps also the term of the loan.

A variation on this would be to apply for a credit card with a low-introductory rate and use that to consolidate outstanding credit card debts. However, a consumer who takes this route should refrain from spending, using the paid-off cards.

Good time to take a second look at your home

Although economists said the Fed cut will not affect mortgage rates directly, they agreed this still is a favorable time to buy a new home or refinance an existing one when you compare current mortgage rates with those of a year ago.

Doug Duncan, chief economist of the Mortgage Bankers Association of America, said the current 30-year fixed and one-year ARM rates are about 1.1 percent and 2.1 percent less, respectively, than they were this time last year.

In particular, refinancing is a valuable way for homeowners to save money. Aside from taking advantage of lower interest rates, homeowners can refinance to withdraw cash or equity from the home, shorten the term of the mortgage, or switch from an ARM to a fixed rate. Whatever the motivation, certain factors should be taken into account.

Generally speaking, homeowners should consider refinancing when current interest rates are at least 1 percent below the rate at which the mortgage was taken out. This is a drop from the traditional 2 percent rule-of-thumb, "because the mortgage origination process has driven some costs out of it that would merit that decline," Duncan said.

Homeowners who are well into the term of their mortgage should consider shortening the term, especially if it would not affect the amount of their monthly payment. Duncan cites his own situation, where he has paid 8 years of a 30-year mortgage.

"It would not make sense for me to refinance and go back to a 30-year mortgage. What I might be able to do is refinance into a 15-year mortgage, because interest rates have fallen from when I originally took the mortgage out," he said.

Because 15-year interest rates are typically lower than 30-year rates, Duncan said, the total decline in interest rates may be sufficient so that if he moved from a 30-year to a 15-year mortgage, his payment would not change, but he would knock seven years off his term.

A few things to consider

However, homeowners must fight the temptation to refinance long enough to determine whether the savings are worth the costs of refinancing, which generally range from 2 percent to 4 percent of the outstanding principle.

Even if your lender offers a "no cash refi," this may end up swallowing any potential savings. Duncan said the cost of refinancing is usually swept into the new mortgage, showing itself either in the principle or in the interest rate.

Also, he said, the tax deductibility of points varies in a purchase and refinancing. (A point equals 1 percent of a mortgage loan, and is charged by lenders to make a profit. Borrowers can pay discount points to reduce the interest rate of the mortgage.)

"In a purchase, you can deduct the points in the year that you take out the mortgage and buy the home. In a refinance, you have to amortize those points over the expected life of the mortgage," he said. Thus, homeowners wanting to refinance in order to offset income will be able to deduct only a portion of the points paid.

If a homeowner is planning to move in the near future, it may not be worth it to refinance. Duncan said, homeowners, can calculate how many months they would have to stay in the home to make a refinancing worthwhile by dividing the up-front costs of the refinancing by the monthly savings.

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Outside of the up-front costs, homeowners also should check whether their mortgage is subject to a pre-payment penalty, which some people accept in exchange for a lower interest rate.

Before anything, Duncan said homeowners should first review the terms of their mortgage with the current lender and inquire about alternative structures.

"There is an incentive for the current lender to work out a deal with them, because ... if the borrower takes out a mortgage from a different lender, then the current lender has to go through the financial cost of taking that loan off their books, closing the deed, etc."

Lastly, said Duncan, homeowners should see other lenders.

"No one should talk to just one lender. They should always shop around [with] at least three different lenders," he said. graphic


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How you can benefit from falling interest rates - April 20, 2001