Higher rates begin to slow growth

While the Fed ponders a new hike in interest rates Thursday, some firms already feel the crunch.

Starting next week, Sallie Mae will reset the interest rates on some student loans almost two full percentage points higher than last July. The change will add $5,123 in additional interest to the cost of a college education.

In August, Ty's Toy Box, a small but growing company in northern Kentucky, will renegotiate bank loans – money it needs to finance growth. In the past two years, the interest rate the company pays is already up 1-3/4 percentage points.

As for executives at the Brooklyn-based Dunn Development Corp., which builds affordable housing, they figure it will cost more to borrow money in the future. This will put pressure on the developer to raise rents on their low- and middle-income tenants.

These are just some of the ways past interest-rate increases are rippling through the economy. Economists expect yet another 0.25 percentage point hike Thursday, the Fed's 17th consecutive increase. This will boost short-term interest rates to 5.25 percent, up from 1 percent in April of 2004.

Economists believe the continual rate hikes are finally starting to act as a brake on the economy.

The expectation is for economic growth to slow from 5 percent in the first quarter to about 3 percent for the rest of the year. Tuesday saw yet another sign of rising interest rates: Existing home sales in May dipped 1.2 percent, the third drop in five months. The Conference Board, a business research group, also predicted Tuesday a slowing economy even as its consumer confidence index has edged up slightly.

If the economic data continues to soften, economists anticipate the Fed will want to pause and try to judge how much the higher cost of borrowing money is crimping economic activity.

"At this point the Fed knows there is enough tightening in the pipeline to arrest inflationary pressures and prevent the situation from getting out of control," says Anthony Chan, a New York-based economist at JP Morgan Private Client Services.

"The only reason the Fed has not stopped is the markets – the new Fed chairman, Ben Bernanke, is the new sheriff in town and has to maintain his reputation as an inflation fighter."

The cost of education illustrates the complex effect of climbing interest rates on consumers' pockets. Sallie Mae changes its student loan interest rates only once a year based on the last Treasury bill auction in May. In the past year, that rate has increased nearly two percentage points.

However, the company also gave students thechance earlier this month to consolidate loans and lock-in lower interest rates. An interest-rate savvy student who consolidated would now be saving thousands of dollars in interest.

"We have seen an extraordinary pace of consolidation," says Pat Scherschel, vice president of loan consolidation in Indianapolis.

"Borrowers are rate-sensitive and know a good deal when they see one."

However, there is no doubt interest-rate increases in the housing market are steadily making it more expensive to buy a house. A year ago, a home-buyer would have paid 5.5 percent for a 30-year fixed-rate mortgage. Today, the rate is 6.67 percent. On a $250,000 loan, that would cost an additional $181 a month.

For an adjustable-rate mortgage, the increase is even more expensive. It now costs $308 more each month than a year ago.

The higher rates are definitely having a negative impact on housing demand, says Jim Svinth, the Irvine, California-based chief economist at LendingTree, an online mortgage loan company.

At the moment, he says, the higher rates affect mostly "folks who are really stretching to qualify for, and pay, their mortgage."

Lower-income folks may feel the rising rates more than most.

For example, Dunn Development says higher interest rates in the future will pressure them to raise rents.

"Market-rate guys can pass it on to their market-rate owners or renters, but for our affordable housing buildings, we have a fixed rent and can't do that," says Ben Kornfeind. "For us, it eats into our building."

Main street business also feels the impact of rising rates fairly quickly. Ty's Toy Box has a line of credit that is pegged to the prime interest rate, which has increased in line with each Federal Reserve hike.

So far, the rate rises have yet to slow down Ty's Toy Box, which has found a niche in online toy marketing, DVDs, and T-shirts of cartoon characters ignored by larger companies.

But, the owner of the company, Ty Simpson, says his rising interest cost comes right out of his bottom line.

"Every percentage makes a difference. We don't operate on huge margins," he says.

So far, Mr. Simpson has been able to avoid passing his higher interest costs to customers. But, he says, the rising rates are something he'll have to watch.

"In August, we'll probably have to look at it," says Simpson.

Lauren Duke contribued to this report.

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