What the Fed's Moves Will Mean to Your Loan

The good news: The economic recovery is strong enough that the Federal Reserve will likely raise rates.

The bad news: A variety of consumer loans, from auto loans to 30-year fixed-rate mortgages, will become more expensive.

This week, for the first time in 15 months, the Federal Open Market Committee shifted its assessment of the economy, saying the risk of economic weakness was balanced against the risk of inflation. After 11 rate cuts, this prompts the question of when rates will start to rise -- many think it could come on May 7, at the next Fed meeting. Indeed, the federal funds futures market put the odds of a quarter-point hike in May at 78%.

"I don't think we'll see 11 Fed moves this year, but a hike may happen in June," says D.C. Aiken, senior vice president at mortgage lender Homebanc. Signs of inflation and a more robust than expected economic recovery could push the Fed to take strong action to manage economic risks, he says. As a result, short-term interest rates will rise, taking other rates with it.

The Fed has direct control over two rates: the federal funds rate, or the overnight lending rate banks charge each other, and the discount rate, or the overnight lending rate the Fed charges banks. As a result, Fed moves greatly affect short-term rates, which can directly affect some, but not all, consumer loans -- a discrepancy that can confuse consumers.

A Rising Tide ... Rates are expected to lift across the board
Product	Current Rate	End-of-Year Prediction
30-year fixed-rate mortgage	7.06%	7.75-8.0%
15-year fixed-rate mortgage	6.55	7.5-7.75
One-year ARM	5.49	6.3
Home equity line of credit	5.2	7.5
Credit card rate, national average	13.05	15.0-15.5
Auto loans	8.41	9.25
One-year CD	2.12	3.25
Five-year CD	4.3	5.5
Source: Greg McBride, Bankrate.com

Breaking It Down

"People tend to think that when the Fed cuts rates, mortgage rates are going to fall," says Doug Duncan, chief economist for the Mortgage Bankers Association of America. But in actuality, he says, the Fed has little effect on a 30-year fixed-rate mortgage, because rates on longer-term loans rise and fall with perceived inflation risk. The 10-year Treasury yield is an excellent barometer of this risk, he says, making its movement a good way to gauge mortgage rates.

"The bond market has already been adjusting," Duncan says, noting the rise in both 30-year mortgage rates and 10-year Treasury yields. Since mid-February, 30-year mortgage rates rose from 6.84% to 7.06%, according to Bankrate.com, while 10-year yields rose from 4.9% to 5.3%. Duncan predicts 30-year fixed mortgage rates will hit 7.5% by year's end.

While mortgage rates will be nowhere near the mid-6% range seen in November 2001, they will remain relatively cheap, below the historical average of 8% for the rest of the year. Similarly, refinancing won't be as attractive, with fixed-rate second mortgages trending in line with first mortgages, says Greg McBride, financial analyst with Bankrate.com.

Home equity lines of credit are priced not against the risk of inflation but against short-term rates, specifically the prime rate, which is what banks charge high-quality customers for short-term loans. The prime rate moves with the fed funds rate, which the Fed directly controls, and as a result, "rates on a home equity line of credit will begin to increase once the Fed is active," says McBride.

Adjustable-rate mortgages, or ARMs, are also priced off short-term Treasuries. In the first year of an ARM, homeowners pay a low fixed rate, but after a year, that rate varies along with an underlying short-term index, typically the one-year Treasury bill. Because Fed hikes raise rates on a variety of short-term indexes, ARMs will get more expensive overall. "A rising tide tends to lift all boats," McBride says.

Once the Fed starts raising rates, rates on ARMs will rise rapidly. "Shorter-term instruments will move quicker in larger increments. That's the nature of the beast," says Aiken, who says the rate on a one-year ARM backed by the one-year Treasury will hit 6.5% by year-end, up from the current 5.49%.

Treasury Yields Fell as the Fed Cut ...
Treasury	Yield on March 19, 2001	Yield on Sept. 19, 2001
One-year	4.24%	2.46%
Five-year	4.53	3.81
Seven-year	4.29	2.81
10-year	4.81	4.77
Source: Baseline

... But Are Rising as the Recovery Takes Hold
Treasury	Yield on February 19, 2002	Yield on March 19, 2002
One-year	2.06%	2.52%
Five-year	4.19	4.71
Seven-year	2.93	3.57
10-year	4.87	5.33
Source: Baseline

Pay attention to the index that affects your adjustable-rate mortgage. ARMs tied to short-term Treasuries will be affected the most, says Eric Tyson, author of Mortgages for Dummies. But he says those pegged to the 11th District Cost of Funds Index (COFI), a moving average of interest rates that bankers in California, Arizona and Nevada charge, won't move as much.

Hybrid mortgages, adjustable-rate mortgages with a longer initial fixed-rate period typically lasting three, five or seven years, also will get more expensive, because they're indexed to Treasuries. If you have a hybrid mortgage that starts adjusting this year, McBride recommends looking at how it's priced, to avoid surprises.

Plastic, Rubber and Chrome

Not only are home loans getting pricier, but credit card rates also could skyrocket this year. Like home equity lines of credit, credit cards are tied to the prime rate, but they tack on a hefty premium because they take on additional risk by lending without collateral.

According to Bankrate.com, the current national average credit card rate is 13.05%, but by the end of 2002, McBride says, rates could jump to 15.5% "if the Fed were particularly active." In the next few months, credit card rates won't move much but will rise sharply as soon as the Fed hikes. "There's a strong correlation between the Fed and credit cards," he says.

Automobile loans, also priced to the prime rate, should move from 8.41% to 9.25% by year's end, McBride says.

A Silver Lining

While loans will be more expensive, savings will earn more. After falling sharply due to 11 straight cuts from the Fed, rates on certificates of deposit, or CDs, will slowly come back. As the Fed cuts short-term rates, CD rates fall quickly as bankers try to keep pace with the moves and keep turning a profit. But when the Fed begins to raise rates, bankers feel no pressure to pay CD holders higher rates, raising rates slowly and reaping the profits.

As a result, McBride predicts five-year CDs will yield 5.5% by year-end, while the one-year will yield 3.25%. In the fall of 2000, a five-year CD yielded 6.2%, a five-year high, but it now sits at 4.3%. The one-year CD hit 5.67% in fall 2000, also a five-year high, but now yields only 2.12%.

"They'll move higher this year, but probably not back to those five-year highs," McBride says.