Despite forecasts of a more tepid pace of economic recovery in 2010 and subdued inflation continuing throughout the year, it is only a matter of time before the Federal Reserve resorts to their primary tool of monetary policy and begins to boost interest rates. Maybe it happens late in 2010, maybe not until 2011. But eventually, it will happen.
And that is exactly why consumers need to prepare now for the inevitability of higher interest rates. Don't wait until the Federal Reserve sends a clear signal about coming interest rate hikes or announces a change in interest rates. Instead, now is the time for borrowers to focus on paying down debt and refinancing to lock in fixed rates. For depositors, it is prudent to continue favoring short-term maturities and preserving the flexibility to lock in longer-term yields once interest rates have begun to rise.
Paying down or paying off high interest rate debt such as credit cards and personal loans should be a top priority, as variable credit card rates will only march higher over the next couple of years. Ditching adjustable-rate debt, such as mortgages, in favor of a low fixed rate is also important for those who are able to refinance. Even many low-rate home equity lines will look less attractive once interest rates begin to rise, so strong consideration should be given to paying down this debt while rates are low. Paying off a home equity line will also make it easier to refinance a first mortgage into a low fixed rate as it avoids the messy issue of resubordination, where second-lien holding home equity lenders refuse to stay second in line when a first mortgage is paid off and subsequently refinanced.
Even though savings yields are low, they are low across the interest rate spectrum. In other words, there is little benefit in stretching into a longer maturity to chase a yield that is only marginally higher, especially considering the findings of Bankrate.com’s survey of CD early withdrawal penalties. The typical penalty for early withdrawal on maturities less than one year is three months worth of interest. For maturities of one year and longer, the penalty is most often six months of interest. And 92 percent of institutions surveyed will devour principal in order to cover the early withdrawal penalty if there are insufficient interest earnings to cover it.
So the most prudent move for most savers will be to retain flexibility to reinvest in a more favorable environment. If you want to calculate what an early withdrawal penalty will cost, use this Bankrate.com calculator to evaluate the interest earnings over various time horizons, keeping in mind that it is the most recent interest earnings forfeited under early withdrawal.