Thursday, January 24, 2008

Tax rebates, interest rate cuts, and personal finance

In response to the signs of a weakening economy, the Federal Open Market Committee (FOMC) of the Federal Reserve System lowered on Tuesday its target for the federal funds interest rate. Today, the White House and Democrats from the House of Representatives announced a tentative deal on fiscal stimulus package that would likely provide tax rebates to low- and middle-income families.

The FOMC decision only directly affects the federal funds rate, the interest rate that banks charge each other when they lend through the Federal Reserve. However, many other interest rates key off the federal funds rate, so rates available to consumers are likely to fall. The stimulus package, should it actually pass, should put money directly into people's pockets.

Both actions are intended to spur people to spend more and reinvigorate the economy. This is likely to happen, at least to some extent.

For many Americans, however, it might be worthwhile to look at how lower interest rates and some extra cash might help their permanent personal finances.

According to the last Survey of Consumer Finances conducted in 2004, three-quarters of American families held some debt. Four out of nine American families had outstanding credit card balances. Families with incomes between $40K and $90K were especially likely to owe the credit card companies. If your family is in this group, it would be a good idea to use the tax rebate and the possibly reduced interest rate to attack that credit card balance. With current rates for many families at usurious rates of 18, 21, or even higher percentages, an extra payment toward the credit card balance would provide a much higher return in terms of the household's net worth than almost any investment on the market.

Lower interest rates also mean that it is a good time for households to refinance their mortgages and lower their indebtness. During the credit expansion that accompanied the housing bubble, many families took advantage of the lower interest rates and easy financing to borrow extra amounts against what they and the banks thought was the value of their homes. Refinancing, however, can also be used to decrease indebtedness. The simplest way to do this is to leave all of the terms of the mortgage the same, except the interest rate--that is, to refinance without taking any extra money out and without extending the period of the mortgage. Some people also took advantage of the lower rates to actually cut the length of their loans. For households with interest-only mortgages or amortizations greater than 30 years, a standard 30-year, fixed-rate mortgage may now be within reach.

Unsustainable run-ups in debt have been a big contributor to the current economic problems. Fixing some of those individual problems might reduce the immediate effects of the stimulus measures but would go a long way toward fixing the underlying, long-term problems in the economy. In any case, it would help some people sleep easier at night.