Entrepreneur Insight

What You Need to Know Before the Fed Raises Interest Rates

For consumers and businesses, taking actions now can save you money in the long run.

Both consumers and entrepreneurs need to keep an eye on interest rates, whether it is for their mortgage, credit cards, business loans for equipment or capital improvements, since the Federal Reserve meets again in December.

While experts have not agreed on whether the Fed will raise interest rates next month, being aware of how an interest rate hike could affect monthly interest payments is critical. Business owners with variable rate loans may want to consider using an interest rate risk management product to mitigate the financial impact to their company in case short-term interest rates start to march upward.

Mortgages

Now is a good time to check the details of your mortgage terms, said Bruce McClary, spokesman for the National Foundation for Credit Counseling, a Washington, D.C.-based national non-profit organization. If you have an adjustable rate mortgage such as a 7-year or 5-year ARM, it is helpful to know when the next rate change will take place.

“Knowing those details can help when it comes time to review your household budget,” said McClary.

Refinancing could also be an option, and homeowners could save tens of thousands of dollars in interest. A 1 percent difference in the mortgage rate can save a homeowner $40,000 over 30 years for a mortgage valued at $200,000, McClary said.

Credit cards and student loans

Since most credit cards come with a variable rate, you can expect to see changes when the Fed raises rates. Consumers who carry a balance on their cards should attempt to take steps to speed up the repayment process before the rate goes up.

“As an alternative, you can also consider moving those balances to a card that offers interest-free transfers for an introductory period,” McClary said. “Just be sure to pay the balance off before the clock runs out on the zero percent interest.”

Likewise, some private student loans can have variable interest rates and borrowers should check the terms to see how they may be affected by a Fed rate increase and alter their budget, McClary said.

Small business loans

The three most common interest rate risk management products used by business owners are caps, collars and swaps, said Jim Haugen, senior managing director and head of interest rate contracts at East West Bank.

An interest rate cap is a financial contract which promises to pay the business owner a specified cash amount whenever short-term interest rates (e.g. prime or LIBOR) rise above a specified level. For example, a business owner could purchase a prime cap that would deliver monthly cash payments whenever prime is above 5.00 percent. If the business owner had a $5 million variable rate loan, he/she could size the cap to cover all or a portion of the $5 million loan. The business owner also has the freedom to choose the level of the cap. Of course, the longer the term of the cap and the lower the level of the cap, the greater the cost of the cap, Haugen said.

Since caps require the payment of an upfront fee, many business owners prefer alternative interest rate protection products which do not require the business owner to pay an upfront fee. One such alternative is an interest rate collar. An interest rate collar is an interest rate cap combined with an interest rate floor. For example, a business owner could obtain a prime cap at 5.00 percent for “free,” provided that he/she was willing to accept a prime floor at 3.50 percent. The floor would obligate the business owner to make monthly payments whenever prime is below 3.50 percent.

Caps, collars, and swaps are three most common interest rate risk management products used by business owners. (Photo credit): Gettyimages.com/DNY59

"Interest rate protection products are powerful financial tools that can help business owners effectively and efficiently manage the damaging impact of significant movements in interest rates."

- Jim Haugen

The final interest rate protection product that is commonly used by business owners is an interest rate swap. A swap is a collar that has a cap level and a floor level that are at exactly the same rate. For example, a 4.75 percent prime swap is the same as a prime collar with a cap level at 4.75 percent and a floor level at 4.75 percent. If a business owner were to enter into a 4.75 percent prime swap, he/she would receive monthly cash payments whenever prime was above 4.75 percent, but would have to make cash payments whenever prime was below 4.75 percent.

Out of these three products, the one which proves to be the most cost effective choice for the business owner depends on what happens to short-term interest rates during the term of the interest rate contracts, Haugen said. If short-term rates move back down, caps will be the best choice. If short-term rates remain unchanged or move only modestly higher, collars will prove to be the most cost effective option. However, if short-term rates move moderately or sharply higher, swaps will yield the greatest benefits.

“Our job is to help our customers choose the interest rate protection product that is the best fit for their particular situation,” Haugen added. “One of the most valuable aspects of these products is that they can be easily customized to match the particular interest rate risk management objectives of individual customers. The recent election has introduced a heightened degree of uncertainty in the financial markets. Interest rate protection products are powerful financial tools that can help business owners effectively and efficiently manage the damaging impact of significant movements in interest rates.”