Inflation Threatens Some Borrowers, Hurts Others

Inflation concerns continue to grow. This means higher interest rates for consumers may not be far behind.

Rising inflation is good news for borrowers who hold fixed-rate mortgages or other fixed-rate loans -- but it means higher monthly payments for borrowers who hold variable-rate loans such as adjustable-rate mortgages.

In its March 18 decision, the Federal Reserve cited "elevated" inflation and rising indicators of "inflation expectations," even as it made an additional cut in the federal funds rate, the overnight lending rate used by banks.

Eugenio Alemán, vice president and senior economist at Wells Fargo Bank WFC agrees: "I may be in the minority, but I believe that the risk of higher inflation in the future is one of the biggest threats to the U.S. economy today."

Alemán adds that recessions normally control inflation, but that this doesn't appear to be happening. "The weakened U.S. dollar is driving inflation, aided by lots of money in the system and the expectation of rising rates," he says.

The inflation rate has declined a quarter percentage point from the start of the year, thanks to the weakened economy. But the rate is still 4%, up from 2% three years ago. "Think how high prices would be if the economy wasn't weak," Aleman says.

Once the economy recovers, prices may rise even more quickly. At that point, the Federal Reserve will need to raise interest rates to control inflation.

Rising rates aren't bad news for all borrowers. If you hold a long-term fixed rate loan, higher rates won't affect your payments. What's more, rising inflation will reduce the value of your monthly payments. For example, an inflation rate of 4% reduces the value of a $2,000 monthly payment to $1,643 in today's dollars over five years.

By contrast, borrowers with variable-rate debt suffer from rising rates. Say that you qualified for a 30-year 3/1-year ARM (an adjustable rate mortgage whose rate is fixed for three years and then adjusts annually) at a rate of 5.5%. Your payments for the first three years would be $1,135 a month on a $200,000 mortgage.

A one percentage point increase in rates will boost your payments to $1,255 -- and a three percentage point increase in rates could leave you with a monthly mortgage payment of $1509. That's an extra $374 you'll need to come up with each month, assuming rates don't climb even further.

What can you do to avoid ending up with bigger loan payments down the road? For starters, if you are choosing between a fixed- and variable-rate loan, you might want to go with the fixed-rate loan.

If you already have a variable-rate loan like a home equity line of credit (HELOC), then consider paying it off with a fixed-rate second mortgage. Alternatively, if the rate on your existing mortgage is higher than today's rates consider refinancing and rolling the balance of your HELOC into your new mortgage.

Here's a look at the national averages for loan rates on various types of mortgages and home-equity loans:

To search for local rates, click here.