Sunday, April 11, 2010

Higher Interest Rates Poses Pesky Problems

Only in financial terms can three decades of low interest rates be described as a honeymoon for home buyers and credit card consumers. As the nation creeps out of the recession. higher interest rates are a foregone conclusion -- perhaps between 1% and 1.5% annually.

The good news from financial sources interviewed by the New York Times is rate hikes will not reach the 1981 pinnacle of 18.2% for home mortgages during the Carter administration. The gradual increases are designed to offset an expected rise in inflation.

The bad news is the increase in prime lending rates may bring the gradual rise in home sales to a screeching halt and consumer credit spending definitely more expensive. Both have experienced painful gains during the second half of President Obama's first year in office.

The rate for a 30-year fixed rate mortgage has risen half a point since December, hitting 5.31 last week, the highest level since last summer. Putting additional pressure for higher rates is the Federal Reserve suspending a $1.25 trillion emergency mortgage debt program designed but largely failed to help homeowners.

Each increase of 1 percentage point in rates adds as much as 19 percent to the total cost of a home, according to Christopher J. Mayer, a professor of finance and economics at Columbia Business School. “It’s a really big risk,” he said, referring to the Fed policy for increasing the prime and expected collateral damage of slowing home sales.

Consumer credit cards reached 14.26% in February compared to 12.03% in the final quarter of 2008. That increase reflects an additional $200 annual increase in interest payments for the typical American households. Because of tight credit and credit card defaults, interest rates on credit cards may reach 17% by this fall, according to Dennis Moroney, a research director at the TowerGroup, a financial research company.

The recession witnessed a major transformation for consumer buying habits as those able to keep their homes even with under water value began saving more and paying off debt. Even at that, household debt nationally is $13.5 trillion exceeding disposable income by $2.5 trillion, according to the Times story.

Washington, too, is expecting to have to pay more to borrow the money it needs for programs. The Office of Management and Budget expects the rate on the benchmark 10-year United States Treasury note to remain close to 3.9 percent for the rest of the year, but then rise to 4.5% in 2011 and 5% in 2012.

The run-up in rates is quickening as investors steer more of their money away from bonds and as Washington unplugs the economic life support programs that kept rates low through the financial crisis. Mortgage rates and car loans are linked to the yield on long-term bonds. 

“We’ve gotten spoiled by the idea that interest rates will stay in the low single-digits forever,” said Jim Caron, an interest rate strategist with Morgan Stanley. “We’ve also had a generation of consumers and investors get used to low rates.” 



The fed is playing with fire. The timing of increasing prime interest rates is crucial to nip inflation in the bud while at the same time not dealing a death blow to the housing market and consumer credit spending. If it can juggle that successfully, it will be good for most American households. With easy money a thing of the past, consumers already have learned the value of saving, paying off debt and stop using their homes as ATM machines. We seem to get the hang of living within our means a far cry quicker than the culture in Washington.

Readers comments are welcome. We reserve the right to delete any comments that are vulgar, libelous and totally irrelevant to this posting. -- Jer

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