How interest rates affect credit

Most credit products have an interest rate that is linked to the prime rate -- the benchmark banks use to determine what they will charge on loans to their customers. The rate may be fixed for a particular term or variable, meaning it fluctuates up and down with prime.

The prime rate typically moves when the Federal Reserve Board adjusts the federal funds rate, the rate banks pay for overnight loans. So if you have a variable rate loan, or are planning to apply for a loan, it’s worth paying attention when the Fed meets, which is generally every six weeks.

When interest rates are rising:

  • Fixed-rate loans are usually better when interest rates are rising, especially if you anticipate an increase of more than a percentage point or two during the course of your loan. Fixed rates are those in which the interest and principal payments do not change over the life of the loan. The majority of home and car loans are fixed-rate.
  • Consider locking in a fixed-rate mortgage, especially if you plan to live in your home more than five to seven years. A hybrid mortgage that starts out with a fixed rate, but then converts after three, five or 10 years to an adjustable-rate mortgage (ARM), can result in an even lower initial interest rate.
  • "Stress test" your adjustable-rate loan or mortgage to see if you will still be able to afford the monthly payments at various higher rates. Interest-only mortgages are a possibility if rates rise beyond your ability to make the monthly payments.
  • Pay off high-interest credit cards with a fixed-rate home equity loan in which the interest is often tax deductible (consult your tax advisor about your particular situation). Not only will this lower your monthly payments, but the lower rates will help improve your credit score, although the loan will now be secured by your home. Although some credit cards offer "fixed rates," all cards are really adjustable upon 15 days notice by the issuer. Paying your credit card balances down below 50 percent of the card limit may help you negotiate a better interest rate from your lender.
  • Consider moving up the timing of a major purchase, such as a house, car, or appliance to beat the rising rates.

When interest rates are falling:

  • Consider an adjustable-rate mortgage. Variable rates are generally more attractive in stable or falling rate environments, as the monthly payments are adjustable based on changes in interest rates. In addition, adjustable-rate loans usually have a lower initial interest rate than fixed loans. For example, at the end of 2004, the average rate on a 30-year fixed-rate mortgage was 5.84 percent versus 4.09 percent on a one-year adjustable-rate mortgage. On a $100,000 mortgage, the fixed-rate monthly payment would have been $589 a month, compared with $482 for the adjustable-rate mortgage, a difference of $106 per month. Of course, you risk a higher interest rate if rates rise.
  • Contemplate a mortgage refinance or auto refinance at a lower rate. Home, car, and consumer (including credit card) loans are typically tied to an index that fluctuates depending on how much interest the federal government pays on Treasury bills and notes. Fixed mortgage rates, for example, fluctuate with the 10-year Treasury note, which is often determined by the longer-term outlook for inflation. On the other hand, fixed auto loans usually track three- or five-year Treasury bills. Lenders mainly adjust loan rates on a weekly basis.
  • Consider paying off high interest credit cards with a home equity loan or line of credit, since home equity rates generally fall faster than credit card rates. Home equity lines of credit typically move immediately after the Federal Reserve raises or lowers the federal funds rate, but credit cards may adjust more slowly depending upon the lender’s cost of funds. Remember though, that your home will now serve as collateral for the loan.
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