What’s the Best Way to Manage Debt as Interest Rates Go Up?

The Federal Reserve has begun to raise the nation’s main interest rate, and that means consumers with debt will need to act fast if they want to avoid rising monthly payments.

As the federal funds rate rises, interest rates on some types of debt will move higher. That means people who hold these debts likely will see their borrowing costs increase a little more with each new rate hike unless they take action now to stop those costs from escalating.

2 Types of Credit: Revolving and Installment

How significantly will the Fed’s rate hikes impact you? It largely depends on the nature of the debt you hold.

There are two major types of credit: Revolving credit and installment credit.

Revolving credit offers you a maximum amount of money you can borrow. You can either pay off the balance you borrow monthly or pay a portion of the balance and carry over the rest to the next month.

As long as you don’t hit your credit limit or you make a large enough payment to keep you from going over the limit, and you pay your minimum bill, you can keep borrowing every month as long as the credit line remains open.

Installment credit allows you to borrow a set amount of money in a loan that you repay over time. Unlike with revolving credit, once you pay off this type of loan, you cannot use it to borrow additional money.

Federal Reserve interest rate hikes can impact both revolving credit — such as credit cards and home equity lines of credit — and some forms of installment credit, such as adjustable-rate mortgages.

However, those who use revolving credit usually are hit hardest when the Fed increases rates. Lenders tend to increase the interest rate on revolving credit as the federal funds rate rise. That means monthly payments on things like credit cards and home equity lines of credit can move sharply higher over time if the federal funds rate keeps rising.

How to Prevent Monthly Payments From Soaring

If you are stuck with revolving credit debt, your best bet is to pay off all or as much of that debt as you can as fast as you can. That way, you can step off the tracks and simply watch as the oncoming freight train of higher rates — and ballooning borrowing costs — arrives.

But if you cannot pay off your debts, you have another option: Taking out a fixed-rate installment loan such as a personal loan and using it to pay off your revolving credit debts. By consolidating such debts in this way, you have the peace of mind going forward of a fixed payment that will not change regardless of what the Fed does in the future. You can use an installment loan calculator to get a good idea of what your payments will be depending on how much money you borrow and your loan’s interest rate.

For example, if you have crushing credit card debts, you can consolidate them into a single debt on a personal loan. Then, you pay off the personal loan over time without the worry of escalating monthly payments.

Personal loans tend to have significantly lower interest rates than credit cards, so the savings can be substantial when you consolidate debt in this way.

You Need to Make a Decision About Your Debt

If you plan to use a debt consolidation personal loan to pay off credit card debt, you probably will want to act fast.

While rates on existing personal loans will not go anywhere regardless of what the Fed does, the rates on new personal loans are sure to climb roughly in tandem with the federal funds rate.

That means a personal loan you take out today is likely to have a lower interest rate — and thus, to be less costly over time — than a loan you take out six months or a year from now. The key is to lock into a rate on a new personal loan before those rates climb too high.

Anything could happen, of course, and the future is always unknown. However, given that the Fed has signaled its intention to raise rates many times over the next year or so, there is a good chance that personal loan rates are now as low as they will be in the foreseeable future.

Couple that with the fact that credit card costs are like to increase soon and very well might continue to climb higher, this may be the time to lock in a personal loan rate.

Is There a Downside of Using a Personal Loan to Pay Off Debts?

While many borrowers can benefit from using a personal loan to pay off their credit card debt, this strategy is not for everyone.

For starters, you might not qualify for a personal loan. This is especially true if you have poor credit, which is often the case for people overwhelmed by credit card debt.

Even if you do qualify, rates on personal loans — although usually substantially lower than credit card rates — are still relatively high, especially compared to something like a home equity line of credit. If your credit score is on the lower side, you may end up saddled with a much higher rate on a personal loan than you had hoped.

Personal loans often come with fees that make them more expensive. And although the lower interest rate on a personal loan is likely to save you money over the long run, in the short run your monthly payment is likely to be higher on a personal loan than it was on a credit card.

Debt Consolidation: Is Now the Time?

Does it make sense to use a personal loan to consolidate other debts? In some cases, the answer is yes, especially in an environment where the Federal Reserve is pushing the federal funds rate higher in hopes of snuffing out runaway inflation.

But this approach only makes sense for those who have run up debts in the past, have learned the error of their ways, and are determined not to fall into that pattern again.

When you pay off your credit card debts, it can appear as if you have a fresh slate. If you go back to your bad habits of using plastic to live beyond your means, you will end up right back where you began, but with a twist: You now will have to pay off both your new credit card debts and your personal loan debt.

So, before you take the plunge and use a personal loan to consolidate debt, it might make sense to sit down with a nonprofit credit counselor to talk about your debt situation and explore which debt management options might be right for you.