Harness your debt with rock-bottom rates

Rates are at historic lows

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Rates are at historic lows

It’s hard to walk into a bank nowadays without seeing a banner touting historically low interest rates. Consumers have an opportunity to take advantage of these rates for the next three years because the Federal Reserve has vowed to keep interest rates low for at least that long.

But what’s the best interest rate play for you?

Some consumers may be looking to utilize low rates to spend money or earn money, says Eleanor Blayney, consumer advocate with the Washington, D.C.-based Certified Financial Planner Board of Standards Inc.

Even so, financial experts advise repaying debts and considering major purchases with low-interest loans — but only if paying them off in a timely fashion is doable.

Still, all is not lost for investors. Consumers can get respectable returns by directing their money toward low-interest debts in lieu of savings or exploring alternative forms of investment.

Here are five tips for getting big gains out of rock-bottom rates.

Clear away debt
Clear away debt

With investment accounts bearing little fruit, consumers can instead build wealth by paying down loans and credit cards.

Even though low interest rates don’t necessarily mean lower credit card rates, consumers can yield greater returns through debt repayment than they would through traditional investments.

You might be better off paying off a car loan with 8 percent interest than holding that money in a savings account bearing a 1 percent return or a certificate of deposit that pays 1 percent or less, Blayney says.

“Nowadays, you get almost nothing to keep your money at a bank and often (pay) to keep your money there,” Blayney says.

Restructure and refinance
Restructure and refinance

It’s a good idea to consolidate debt into one loan at a low interest rate, says Nessa Feddis, vice president and senior counsel for the American Bankers Association in Washington, D.C. If you have outstanding balances on several credit cards, consider transferring those balances to one credit card with the lowest interest rate. Consumers with good credit histories might be able to negotiate lower rates, Feddis says.

By refinancing a mortgage, borrowers also might be able to exit a risky adjustable-rate loan for a more stable fixed-rate mortgage.

Homeowners who took out a 7 percent 30-year mortgage and bought a $225,000 house five years ago have paid more than $76,000 in interest. Refinancing at 3.5 percent with a 15-year mortgage will save almost $175,000 over the life of the loan and shave off almost 10 years’ worth of payments by adding only $25 per month to the mortgage payment.

A home equity line of credit is another way to consolidate debt, make home improvements or borrow for education.

Still, mortgage refinancing and obtaining a HELOC aren’t possible for everyone. In some markets, homeowners may have a difficult time because falling real estate values have slashed their home’s equity, Feddis says.

Refinancing means lower monthly payments, but only because the borrower will repay a lower-interest loan over a longer time period, says Blayney of the CFP Board. “What people have to be aware of is that if they are refinancing, they’re setting the clock back to zero,” she says.

Buy a big-ticket item
Buy a big-ticket item

By borrowing for a home, car or other large purchase, consumers can take advantage of superlow interest rates and, in some cases, interest-free loans.

Real estate values have decreased, rates on long-term fixed-rate mortgages are at their lowest in decades, and there’s a good supply of homes available.

In addition, there are car deals to be had for people who qualify for an auto loan, says Laura Creamer, financial education specialist with CredAbility, a nonprofit credit counseling agency in Atlanta.

Although great deals abound, consumers should be careful not to take on too much debt. The Federal Housing Administration recommends that no more than 43 percent of your gross income be used for housing, debt and other financial obligations.

Making a large purchase is a good idea only if you have a good credit record and can pay off the loan, Feddis says. Before applying for any loan or credit card, check your credit report, and learn your credit score.

“Make sure your score is higher than about 680 to qualify for the very best rates,” Feddis says. If it’s anything lower, pay down balances, remove errors from your credit report, and pay bills on time to raise your credit score.

Invest with caution
Invest with caution

The downside of low interest rates is that the investment landscape isn’t what it was five years ago. Talk to a financial adviser to review your investments, and see how you can get the most bang for your investment buck, Creamer says.

Blayney says be wary of chasing yields. Investors can be tempted to go after bond yields and other fixed-income investments that pay much more, but greater risk accompanies higher returns. “People think 12 percent is better than 1 percent. It’s not, if you’re not going to get it,” Blayney says.

Alternative investments are another strategy, and one option is to set up an intrafamily loan. Loans between parents and children have picked up substantially because of lower interest rates, says Jennifer Bordes, director of tax consulting services for LaPorte CPAs and Business Advisors in New Orleans.

Parents can help children and siblings to pay off their own debts at a lower rate than they would get from a bank.

Investors need to do this cautiously and seek help from an attorney or Certified Financial Planner to draw up a promissory note to spell out rates and terms, Blayney says.

“Sometimes people feel that if they’re borrowing money from a family member, it’s not real debt,” she says.

Give someone a gift
Give someone a gift

Consumers have the opportunity to do some large-scale gifting or wealth transfers and save on taxes down the road.

Low interest rates are coinciding with the increase in the estate tax exemption, which could subject smaller estates to federal taxes in 2013.

“Given both of these factors, it makes it much more attractive for people to do these gifting strategies,” Bordes says.

Right now, estates up to $5.12 million don’t pay federal taxes. Without legislative action, that rule is scheduled to sunset at the end of 2012. The exemption will drop to $1 million, meaning estates surpassing that amount will owe taxes in 2013.

Giving outright monetary gifts and loans at today’s low rates can reduce the value — and ultimately the estate tax potential — of an inheritance, Bordes says. That’s especially true for investors nearing retirement.

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