The uneven burden of money's higher cost

The cost of being a borrower is rising.

As the Federal Reserve raises interest rates - as it is expected to do again Tuesday - everyone from students to car buyers to anyone carrying a credit-card balance will start to notice that lenders are charging more.

At this point, the actual impact on the economy as a whole is relatively modest. It won't stop consumers from spending. However, the impact is disproportionate - falling more on lower- and middle-income wage earners - and will affect almost everyone who borrows.

"The impact is about the equivalent of a 15 cent increase in the cost of gasoline," says economist Mark Zandi of Economy.com. "In fact, we are getting both - we are paying more for gasoline and servicing our debt."

Tuesday, when the Federal Reserve meets to set interest-rate policy, it is widely anticipated it will continue this trend by hiking rates another 1/4 of a percent, as it has been doing since last May.

So far, it's raised interest rates by 1/4 of a percentage point six times. The latest increase would move the Fed Funds rate, a short term measure of borrowing, up to 2 3/4 percent, its highest level since September of 2001.

The Fed is raising rates because it feels interest rates would be too accommodative if they didn't act. Most economists expect the Fed to continue to raise rates in the months ahead. In fact, this month's move will also be parsed carefully to see if the Fed's decisionmakers indicate there are changes taking place in the economy.

"In the past, they said the economy is expanding at a moderate pace," says Lyle Gramley, a former Fed governor. "Now they might call it a steady pace, which sounds more vigorous," says Mr. Gramley, currently a consulting economist at the Schwab Washington Research Group.

The steady Fed rate hikes means costs have risen for many financial institutions who are now passing that added expense on to their borrowers.

Mr. Zandi estimates the rate hikes over the past year have cost consumers about $15 billion. Another four rate increases this year would mean that money would cost about $25 billion more than last spring. This would be equal to about .3 percent of consumer spending, which grew by 6 percent last year.

"It's small but measurable," says Zandi. "It's one more reason to think consumers will not be leading the way as they have in recent years, and this will be particularly felt by lower- and middle-income households."

About two-thirds of all "sub-prime loans," mostly made to lower- and middle-income people, moves up and down with changes in interest rates.

The impact on those who make more money will be somewhat muted because they have locked in low rates through mortgage refinancing. Ten years ago, 35 percent of household liabilities adjusted within a year of a rate change. Today, it's down to 25 percent. "Households in total are less rate sensitive than the past," points out Zandi.

Unfortunately, this won't apply to many students who have outstanding loans. On July 1, more than $200 billion in education loans will have their interest rates reset by lenders.

Currently, students are paying 2.77 percent on their loans and parents are paying 4.17 percent. Based on where interest rates are today, those rates would be reset to 4.49 percent for students and 5.9 percent for parents. On a $20,000 loan, borrowers would pay an extra $2,000 more in interest over the life of the loan, according to Sallie Mae, the nation's largest provider. (Students can lock in a lower rate if they consolidate their loan before July 1. This commits them to pay off the loan over a long term, perhaps as long as 30 years.)

The higher interest rates would affect Indiana University senior Michelle Wehle, who estimates she owes about $20,000. The prospect of paying more interest on the loan, she says, just reinforces her goal of paying the loan off as quickly as possible. "If I have to live without luxuries or whatever, I want to pay it off rather than stringing it out for a number of years," says the finance major.

Car buyers will also notice the higher rates. Last year, some 17 million new cars were purchased and 42 million used cars. According to CNW Research, some 70 percent of new cars were bought with some kind of loan.

Nationally, the average rate on a car loan has risen from 5.21 percent last March to 6.32 percent today, according to bankrate.com. On a $20,000 loan to be repaid over 60 months, the higher rates would add $500 to the cost of the loan, estimates Brian Reed, a vice president of Capital One Auto Finance in San Diego which is charging 4.99 percent for its loans.

"With interest rates rising, consumers need to have the same rigor in researching the financing of the car as they do for the price of the vehicle," says Mr. Reed.

There is no doubt the rising rates are changing some consumers' behavior. For example, Jennifer and Carlos Gonzalez of Massapequa, N.Y., will be closing on a new home on April 15th. They looked at a five-year adjustable rate mortgage (ARM), but decided to lock in a 30-year fixed rate loan, despite a slightly higher interest rate. "We were too nervous about the rates to go with the ARM," says Mrs. Gonzalez.

Monitor Intern Courtney Allison contributed to this story.

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