Posted on: Sunday, April 25, 2004

Creeping rates may transform credit-happy culture

By Paul Blustein and Nell Henderson
Washington Post

The sharply reduced ringing of Jim Foley's phone is a telling sign that the days of rock-bottom interest rates are almost surely ending.

Last month, with interest rates on home loans scraping close to four-decade lows, the Bethesda, Md., mortgage broker was taking more than 100 calls a day, most of them from homeowners who thought they saw one last chance to refinance their mortgages and lock in low borrowing costs before rates headed up.

Today, it looks like those callers were right. The average rate for 30-year fixed-rate mortgages climbed to 5.94 percent last week, up from 5.38 percent in mid-March, according to mortgage giant Freddie Mac. So although Foley's phone hasn't exactly gone cold — he still gets about 50 calls daily — his level of activity is a lot different from early March. "It was crazy, busy" then, he recalled. Now, "it's back to normal."

Higher rates 'normal'

In the world of interest rates, "normal" is something Americans haven't experienced for a while. During the past couple of years, consumers have been spoiled by opportunities to borrow at rates last available generations ago. They took advantage of that cheap credit to buy bigger homes and fancier cars while running up debt on their credit cards and home-equity lines.

Now that rates appear to be headed toward some semblance of normal, a considerable amount of adjustment is likely in store for America's debt-laden economy, as car buyers are weaned from interest-free financing, homeowners get socked with higher charges on their equity lines and monthly credit card bills rise.

Borrowing costs are still far below the inflation-bloated levels of the 1970s and 1980s, of course, and nobody can be certain that the latest run-up won't be reversed. But economists are nearly unanimous in agreeing that because of the recent improvement in the employment picture and last week's report of an increase in consumer prices, the Federal Reserve will start lifting the short-term rates it controls later this year. And the financial markets already have sent longer-term rates upward.

Despite record borrowing, the era of easy credit allowed many Americans to reduce their interest costs on a long-term basis by refinancing their mortgages, consolidating their higher-cost credit card balances, and locking in lower rates in a host of other ways.

Fixed-rates help

The prospect of a rise in rates "is not quite as big a problem as people think, because most lending in the U.S. is now fixed-rate," said David Wyss, chief economist at Standard and Poor's, who offered himself as an example: "I just refinanced my mortgage at a fixed rate, so I don't care what rates do for the next 15 years; I know what my monthly payment is."

Mortgage lending accounts for more than three-quarters of all household debt, although some of those loans are variable-rate. Adjustable-rate mortgages, which typically offer a lower initial rate for a period in return for a rate that can rise or fall later with market conditions, accounted for 30 percent of all mortgage originations in the first three months of this year.

Still, Wyss and other economists worry some about home-equity credit lines, which soared from $150 billion in 2000 to $346 billion at the end of last year. These are generally tied to the prime lending rate, which has remained low but is almost certain to rise in coming months once the Fed starts nudging its own short-term rate higher. And if 30-year mortgage rates reach the 6.5 percent to 7.5 percent range, as many forecasters expect in 2005 and 2006, it is bound to cool the housing market.

"Many households have been 'buying forward' — they bought homes sooner than they normally would have because of very low rates, and that has stolen future housing demand, which will become evident when mortgage rates rise," said Mark Zandi, chief economist at Economy.com, a West Chester, Pa., consultancy. "It will be particularly hard on markets that have been juiced up, like Washington's."

Worries for those in debt

Households with incomes below the median level of about $50,000 have the most to worry about, Zandi said. Among people in the bottom fifth of household income, more than a quarter spend 40 percent or more of their incomes on debt service, according to government figures. "Their balance sheets are fragile, and they are at risk," Zandi said.

As for credit cards, that form of debt was about 70 percent variable a decade ago, but about 60 percent of it is fixed-rate today, according to Robert McKinley, chief executive of CardWeb.com of Frederick, Md. Average rates, though lower than the 1980s, are still high at about 14 percent — only the most creditworthy consumers get low-single-digit rates — and consumers had better beware of "stealth" rate increases soon. Many deals that are advertised as fixed-rate can be changed as long as the credit card company notifies cardholders, so "people need to pay very close attention to their credit card statements," McKinley said.

The force driving rates up is positive — stronger economic growth — which may offset much of the dampening effect of higher borrowing costs on big-ticket items such as autos.