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Rising Interest Rates: Consumers Face Unprecedented Risk

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worried-young-debtorsInterest rates have been rising for the past couple years, which is nothing unusual. Rates are cyclical, meaning they rise and fall naturally over time.

In today's environment, this rising phase of the cycle may present an unprecedented level of risk to American consumers.


Higher interest rates increase the cost of debt. Given that there is currently a record amount of consumer debt outstanding in the United States, the impact of rising rates may be greater than ever. Increasing debt costs have a negative impact on the economy at large. Depending on your debt situation, this could well put a major strain on your household budget.

Using the federal funds rate as an indicator of interest rates in general, the last time the United States went through a rising-interest-rate phase of the cycle was from mid-2004 to mid-2006. American consumers now owe about $200 billion more in credit card debt, $1.5 trillion more in other loans, and over $3 trillion more in mortgages than they did back then. So you see why the economy may be especially vulnerable right now.

The price tag could be an additional $37 billion a year in interest charges to American consumers.

To understand the impact of rising interest rates on the cost of debt, consider two kinds of debt: revolving debt and installment debt.

Rising interest rates: revolving debt

Revolving debt is open-ended financing that is not locked in for a specific term or at a set interest rate; instead, rates and terms are subject to change. That makes revolving debt especially sensitive to rising interest rates.

For the most part, revolving debt is credit card debt. While the 2009 CARD Act restricted the ability of credit card companies to raise interest rates on existing debt, card issuers apply your monthly payments first against older debt. And new charges are usually subject to the new (and possibly higher) interest rate.

So even if the amount you charge every month and the payments you make to your account every month remains the same, over time, new higher rates will apply to a greater portion of your balance, forcing your payments up. Of course, this is not an issue if you don't carry a balance.

The key, when considering the impact of rising rates, is the current level of revolving debt. That's because rising rates will impact credit card accounts before they hit almost any other type of financing. Reducing balances, if possible, offers some protection for your own personal debt situation and for the economy as a whole.

Rising interest rates: installment debt

Installment debt comprises a variety of loans -- auto financing, student loans, personal loans, etc. These typically feature terms and interest rates that are fixed. Therefore, rising rates have less of an impact on them. Mortgages work much the same way, since the vast majority of home loans today are at fixed, rather than adjustable, rates.

For non-revolving debt, then, the risk of rising rates has the greatest impact not on the level of debt but on the flows of debt. How much new debt being taken on each year is a key to how much of that debt will be subject to higher interest rates.

How much revolving debt is there?

Late 2018 marked just the fourth time in history that the amount of revolving debt outstanding topped a trillion dollars, reaching a record $1.045 trillion as of December, 2018.

That means that more credit card debt than ever is vulnerable to rising interest rates, and credit card rates in particular are up. The average rate charged on credit card balances has jumped by 3.25 percent over the past two years. Applied to that $1.045 trillion in revolving credit outstanding, that means that rising interest rates could now cost consumers an extra $33.9 billion in additional interest annually.

What is happening to installment debt?

Installment credit is also at an all-time high, including student loan and auto loan debt.

Because these loan terms and payments are usually fixed, this debt is less sensitive to rising interest rates. However, increasing rates do limit the ability of people to refinance their balances if they need to. Also, the record levels of this debt indicates how much consumers have come to depend on it.

Of course, rising rates will make installment debt less affordable over time. Most, if not all, forms of installment financing have seen rate increases of 1 or 2 percent recently. The net amount of non-revolving debt is increasing at an annual pace of about $170 billion.

Don't forget mortgage debt

In addition, net increases in mortgage debt are running at around $550 billion per year. And mortgage rates are up about 0.5 percent over the last two years.

Combine that with the expansion in consumer financing and you have a total of about $720 billion a year in higher loan balances.

Applying the interest rate increases to additional flows of debt means consumers are paying about $3.4 billion a year more in interest on their new debt.

Don't worry: Be ready for rising interest rates

Between revolving and non-revolving debt, interest rate increases are already likely to cost consumers a total of more than $37 billion a year in additional interest. With record amounts of debt outstanding, this cost could grow if interest rates continue to rise. These nationwide figures are scary, but what should matter most to you is the risk of rising interest rates on your own debt.

Follow the logic used above to do your own cost-of-debt risk analysis. Consider what impact rising interest rates might have on your credit card balances and on any upcoming plans to apply for loans. Avoid new charges to your most expensive credit cards, and pay off those high-interest balances first. This means paying as much as you can toward reducing balances, not just the minimum required by the card issuer.

Consider paying off high-interest revolving balances with an installment loan, which may protect you from future increases and help put you on the path to zeroing out your balances. And plan to apply sooner rather than later so interest rates have less chance to rise and potentially disrupt your plans.

The purpose of drawing attention to the risk of rising interest rates is not to scare you. It is to help you make smart choices about debt. You can't do anything about the record levels of debt nationally, but recognizing the impact that rising rates may have on your own debt can help you make informed decisions about paying down and taking on debt going forward.


More resources on debt

Budgeting tips: 6 mistakes to avoid

Credit Card Interest Calculator: How much interest are you paying?

Credit Card Payoff Calculator: What to pay each month to pay off your credit card

Calculator: Should I switch to a lower interest card?

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