Your Best Interest

Last week the Federal Open Market Committee (FOMC) approved another increase in the interest rate banks charge each other for overnight loans for the 12th time since June 2004. When banks pay more for their loans, they are sure to pass that cost on to their customers.

A Chain Reaction
The reason the Fed increases interest raises rates is to increase the cost of loans. With many individuals facing higher loan payments, the hope is that they will borrow less and spend less on stuff they might be able to live without. Rising interest rates can cause this chain reaction:

• Increased payments on existing adjustable rate loans and new loans,
  
• Wages rise more slowly as companies who rely on borrowing get squeezed by their loan costs and postpone hiring more workers.
  
• Higher loan payments and a slower job market weighs on consumers so they reduce their spending, which should lead to slower price increases of things ranging from cars to homes.

Borrowers Getting the Squeeze
Although the Fed raised interest rates 12 times since last summer, not until recently have interest rates on loans increased. It is only a matter of time that people with loans that adjust to current market rates will find that their cash flow is getting tighter. Those looking to buy a home or a car will have a tougher time affording the monthly payments. Here's a chart of some typical increases:

But these increases will definitely put a strain on the spending of many consumers. People who are over-extended, who have adjustable rate mortgages and use over 30 percent of their gross income to pay debt payments will likely be hurt the most. Folks who opted for adjustable rate mortgages a few years ago will find out that refinancing provides no payment relief when their initial rate expires and adjusts to current higher levels.

Savers Get More Interest
There are a few positives in the Fed's interest rate increases. For starters, people with savings are starting to see increased interest earnings on their monthly statements as many banks and money market funds increase the interest rates they pay depositors. Some of the best rates available are nearly 4 percent, which is 3.5 percentage points more than the typical rates earned by depositors last year - or an increase of about 700 percent! For depositors and savers, interest paid is finally getting interesting again.

But not all banks are increasing the rates they pay account holders. With the average interest rate paid on interest bearing checking accounts at 0.69 percent, many banks are still only offering low interest rates on customer's accounts. For example, according to a search on the Bankrate.com Web site, 7 of the 16 banks, or almost half of the banks searched in a local area, are paying under 2 percent interest on their savings accounts.

Banks are free to set rates they pay depositors wherever they want – if they want to attract deposits, they set rates higher. And if a bank already has a large share of the deposits in their market, there is little incentive for them to offer higher yields. For this reason, it's important to shop around because competing institutions looking to take market share will raise their yields on their accounts and money market funds faster than the rates set by established banks.

And don't expect your bank to call you and tell you that the rate they are paying you is low and that they have other options available that may pay you a higher rate. You should instead contact your bank and ask them what your current rate is on your account there and ask about other higher rate options they may have available.

It's also a good idea to do some research at Web sites such as Bankrate.com to get a sense of the most competitive rates on savings in your area.

If your bank is not offering you higher rates on your savings, check out the rates offered by other web-based banking and financial institutions. Deposits in these web-based banks are also FDIC insured and, typically, there are no fees, no minimum balance requirements and no service charges that apply:

EmigrantDirect.com – American Dream Savings Account.
Interest Rate: 4 percent

CapitalOne.com – High Yield Savings Account.
Interest Rate: 3.75 percent

ING Direct.com – Orange Savings Account.
Interest Rate: 3.5 percent

And using a web-based bank as a parking place for your spare cash is made more convenient with account linking over the web. When you set up the web-based bank account, it can be linked to your existing checking account and funds can be moved between the two over the Internet or over the phone.

Don't think shopping around for higher rates on your savings is worth it? Take a look at the additional monthly interest you can earn on a deposit of $10,000:

In fact, folks considering a safe place to park their longer term savings should consider Series I Savings bonds, which offer an earnings rate that is currently one percent over the semi-annual rate of inflation, or a composite earnings rate of 6.73 percent for such bonds purchased between November and April 1, 2006.

Since these bonds cannot be redeemed during the first year, and an interest penalty applies if redeemed during the first five years, you need to be sure you will leave cash here for at least five years. For more information on Series I Savings Bonds, log onto www.publicdebt.treas.gov.

What to Do Now

On Your Loans:

• Pay down adjustable rate debt, especially if you have extra cash flow on hand. The after-tax cost of most loans is significantly more than the net interest earned on your cash.
  
• Reduce purchases that require you to borrow to make them.
  
• Consider refinancing your Home Equity Loan with a Fixed Rate mortgage.

• Consider stashing some cash in higher yielding money market funds.
  
• Shop around for higher yield savings accounts.
  
• Consider Series I Savings Bonds for longer term savings.
  
• Hold off on purchasing new CDs in anticipation of higher interest rates early next year.