Lower Rates, Higher Jitters Are Flags for Debt-Burdened

Interest rates fell to their lowest level in a generation last week, opening a window of opportunity for individuals to refinance debt, but also raising the risk that borrowing may soon become more expensive.

Thus, it may be time to pull in your horns.

Combined with the possibility of an economic slowdown, falling interest rates mean consumers should be cutting back on their debt load, financial planners say.

Refinancing mortgages, lowering credit card debts and building up an emergency fund can help you weather whatever economic storms lie ahead.

But although loan interest rates are falling, be careful how you proceed. Companies that promise lower interest and mortgage rates may wind up taking more out of your pockets than you’re paying now. Financial planners say keeping your debts low is a good idea under any circumstances, because money spent on interest expenses can’t be used to build wealth.

In addition, any major economic setback, such as a medical problem or a job loss, can quickly escalate into a crisis for people who have too much debt and not enough savings. When a recession hits, the risk grows, since more people will be losing their jobs, and pay increases for those still working will come more slowly if at all.

Kay Larsen, 40, of Glendale knows well the risks of being in hock. Larsen racked up $11,000 in credit card debt after moving to California in the late 1980s. In 1992, she was fired from her secretarial job after suffering repetitive motion injury. Although she eventually won workers’ compensation benefits, the legal struggle and the years without a job have left her $53,000 in debt. Today she makes less than $25,000 a year, has little savings and faces years of heavy debt payments.

“I should have declared bankruptcy years ago, but I try to be a good person and I pay my debts,” Larsen said.

The number of people overwhelmed by debt is escalating. Personal bankruptcies hit a record high of 1.38 million for the 12 months ended in June, and many lenders, including credit giant Visa U.S.A., expect bankruptcies to continue growing by 5% a year regardless of what the economy does.

In good times, consumers tend to borrow more freely and overextend themselves, said Kenneth Crone, Visa’s senior vice president for issuer credit risk. In bad times, the growing number of people unable to pay their debts is partly offset by consumers’ reining in their spending.

“When you look back, you’ll see that [in economic slowdowns], many consumers get more conservative with their spending and actually put their financial houses in order,” Crone said.

Paradoxically, such pulling back can actually prolong or even cause a recession, since two-thirds of the U.S. economy is dependent on consumer spending, according to Bank of America economists.

But financial planners say that when it comes to your financial health, a little selfishness is in order.

“You should never be getting beyond your means, which people have been tending to do with things going so well in recent years,” said Laura Tarbox, a certified financial planner in Newport Beach. “It’s human nature.”

Being in debt could become even more expensive if deflation should ever take hold. Deflation, the opposite of inflation, is a general drop in prices. Economists disagree about the likelihood of deflation hitting American shores, although some precursor signs are evident, such as dropping commodity prices and an increase in cheap imports.

Deflation is important to borrowers because it makes the value of a dollar rise. That means a debt incurred now would cost even more to pay off in the future, since a dollar would be worth more as prices drop. Interest rates would fall, but the real cost to borrow would most likely increase.

Taking Stock

The first step for a debt reduction plan is to take stock of where you are, said Gary Stroth, executive director of the Consumer Credit Counseling Service of Los Angeles, a nonprofit group that helps debt-ridden borrowers negotiate with creditors.

Identifying how much you owe to whom, and at what interest rates, can help you prioritize, Stroth said. The highest interest rate debt, typically credit cards, generally should be paid off first.

Tarbox recently recommended that one client tap a non-retirement investment fund to pay off credit card debt that was accumulating at 22% interest.

Paying off a credit card is like a 16%, 18% or 22% tax-free return on an investment--something that is hard to beat, Tarbox points out. “But it’s amazing how often people do that--leave money in an account when they have credit card debt.”

At the same time, consumers should strive to keep at least a couple of months’ worth of living expenses in a savings or money market account in case of emergency. That fund should be built up to six months or more if a job loss is possible, financial planners say.

In some situations, people may need to free up more money by cutting expenses and increasing income by working overtime or adding a second job, Stroth said. People who spend more than 20% of their take-home income to pay non-mortgage debt, or who can make only minimum payments on their credit cards, are candidates for professional credit counseling, Stroth said.

Refinancing

Some of the biggest savings could lie in refinancing your home loan. Homeowners who haven’t refinanced in recent months may be able to trim hundreds or thousands of dollars from their yearly mortgage payments by replacing their existing loan with one keyed to today’s low rates.

But they could also end up paying so much in fees and interest costs that the new loan becomes a worse deal than their existing mortgage, warns Earl Peattie, president of Mortgage News Co., a Morro Bay firm that tracks mortgage trends.

“The mistake I see is people focusing on APR [annual percentage rate, a common loan rate comparison],” Peattie said. “They don’t get a bottom line of what the loan will cost them.”

Someone who got a $200,000 mortgage in May when rates averaged 7.22%, for example, could theoretically pay $122 less a month, or nearly $44,000 over the life of the loan, by refinancing at today’s rates.

The average rate for a 30-year, fixed mortgage of up to $227,150 in California last week was 6.302%--the lowest rate since Mortgage News began tracking rates 10 years ago, Peattie said. To get that rate, borrowers paid an average of 1.79 points. (Points are a percentage of the total loan, paid to the lender.)

For mortgages above $227,150, known as jumbo loans, the rate for a 30-year, fixed loan was 6.672% with 2 points, Peattie said.

Points, fees and application costs can run up the cost of a loan to the point where refinancing might not make sense, Peattie said. Also, lower payments typically mean a lower tax deduction, which offsets some of the benefit and means the refinance may take longer to pay for itself. People who expect to stay in a home only a few years might not be able to save enough to offset the cost, he said.

Those who have been paying off a loan for 10 or more years should also think carefully about refinancing with another 30-year loan, Peattie said. A better strategy might be to refinance with a 15-year loan, or to not refinance at all.

Lenders often make comparisons difficult by not disclosing loan fees, or disclosing them only after you’ve applied for a loan, Peattie said.

How can you know if a refinance makes sense? As a rough rule of thumb, a drop of 1 percentage point or more may save you money if you plan to stay in a home at least five years. The only way to really know is to crunch the numbers for your own situation, taking into account how long you expect to stay in the home, the fees and points you’d pay, your tax rate and how much lower your monthly payment is expected to be. Many borrowers might need a tax preparer’s help to come up with a reasonable comparison.

“It’s major-league finances, and people who are allergic to calculators probably will break out in hives,” Peattie said.

Credit Cards

Of the $1.3 trillion consumers owe in non-mortgage debt, the $543.8 billion owed on credit cards is the most troublesome, financial planners say.

Credit card debt is typically expensive, with average rates hovering around 16%. It is easy to get overextended, since credit card companies require that you pay only 1% to 2% of your balance each month.

That means a $100 purchase requires only a $2 monthly payment. But at 16% interest, that $100 charge will take 83 months to pay off, for a total cost of $166.

“The finance charges are so high it takes forever to pay them off,” Stroth said. “But it’s so easy [to make just the minimum payment] that people let it slide.”

Until the problem hits crisis proportions. About 6% of credit card accounts are now in arrears each month, and credit card issuers annually write off about 5.5% of their loans--both historic records, said Robert McKinley, president of CardTrak, a Frederick, Md., firm that follows credit card trends.

At the same time many consumers are falling behind, others are learning how to play the credit card game--to the issuers’ detriment. The percentage of customers paying off their bills in full each month is rising, from 26% five years ago to 42% today, McKinley said. These conscientious payers, known in the credit card industry as “deadbeats,” pay no interest and thus are further squeezing card issuers’ profitability.

Those factors, coupled with bank mergers and consolidations that have concentrated half of the credit card market with five top issuers, could mean higher credit card costs to come, McKinley said.

Consumers should expect to see credit card issuers impose new fees and revive annual fees that they previously waived. McKinley also expects the grace period--the number of days a consumer has to pay a bill without incurring interest--to shrink still further. While grace periods of 25 to 30 days were once typical, the average is now 20 days; some issuers have no grace period at all, he said.

Savvy consumers can fight back by moving their credit card debts to low-rate cards and then working to pay their debts off in full, credit counselors say.

Consumers with excellent credit can find fixed rates as low as 9.9% by searching the CardTrak Web site at https://www.cardtrak.com or by calling (800) 344-7714.

Nimble borrowers can take advantage of even lower introductory rates, although they should be prepared to scoot their balance to a new low-rate card once the teaser rate expires, typically in five or six months. Next Card, offered by Heritage Bank of Commerce in San Jose, has introductory rates as low as 2.9% and allows customers to pick a package of rates and fees based on their credit history. Once the introductory rate expires, however, the rate jumps to the prime rate plus 9.9%, for a current total of 18.4%.

Debt Consolidation

The explosion in credit card debt has fueled another borrowing phenomena: the home equity debt consolidation loan.

Touted in radio and television ads, it promises to lower your monthly payments with a loan backed by your home equity. Some lenders go further, offering to lend 125% or more of your home’s value.

Such high loan-to-value lending, as well as home equity loans to people with less-than-perfect credit, has fueled much of the home equity lending boom. Sub-prime and high loan-to-value home equity loans have more than doubled in three years, to $155 billion, said Jeff Zeltzer, executive director of the National Home Equity Mortgage Assn., a trade group that represents sub-prime and high loan-to-value lenders. Loans for more than a home’s value account for about $12 billion of the total, up from virtually zero three years ago.

What borrowers often miss is the high fees they’re paying for the new loan, and the fact that their debts are being stretched out for 15 to 30 years. Consumer advocates complain that the fees often aren’t well disclosed, and that lenders don’t make it clear that any loan over 100% of a home’s value is not tax-deductible.

Borrowers “might be paying twice as much interest, but they have a lower monthly payment, so they think they’re doing better,” Peattie said.

A traditional home equity loan, which taps up to 80% of a home’s equity, can be a solution for some strapped consumers, said Robin Leonard, author of “Money Troubles: Legal Strategies to Cope With Your Debts.” Interest rates on traditional home equity loans range from 8.5% to 14%, fees range from 1% to 5%, and payments can be tax-deductible.

High loan-to-value rates are another matter. Most of these 125% or 135% loans start at 14% interest rates and run 20 to 30 years, with lenders charging 5% to 10% fees, plus application, processing and appraisal fees.

Susan Garwood of Warren, Ind., said she didn’t realize she was paying a $2,300 fee when she applied for a $23,000 loan from Irvine-based Preferred Credit Corp. two years ago to pay off her credit card debt. At 13.99%, the 20-year loan will cost her more than $75,000. Had she moved her balance to a lower-rate card, Warren could have made the same monthly payment and paid off the debt in half the time and at less than half the cost.

Some lenders have attracted the attention of regulators. The state Department of Corporations accused Preferred and another Southland lender, DiTech Funding Corp., of gouging customers by charging interest before their loans were disbursed. Preferred paid a $1-million fine last year and is under new ownership. DiTech’s case is still pending.

The fees and practices in the 125% market have become so notorious that the National Home Equity Mortgage Assn. has proposed legislation to rein in some of the worst offenders.

Like credit counselors, the association says debt consolidation loans are only effective if consumers stop borrowing and concentrate on paying off their debts.

“They should put their credit cards in a drawer” until the loan is paid off, said Jeffrey Zeltzer, the association’s executive director.

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Freelance writer Stephanie Losee in New York contributed to this report.