Here's What You Should Know About Loans in a High Interest Rate Environment

Interest rates in the U.S. have steadily risen since early 2022, and many economic experts project continued increases throughout this year. The Federal Reserve has also suggested that further rate hikes are under consideration. If you are thinking about taking out a loan or opening a new line of credit, this trend has implications you should be aware of.

Adjustments to benchmark interest rates are a key tool in the Fed’s toolbox for balancing inflation and economic growth. When the Fed raises or lowers these rates, it may not directly and immediately affect you, but it does influence what banks and other financial institutions charge for the consumer loans and credit products they offer. That in turn can make borrowing more expensive, whether you’re a first-time home buyer applying for a mortgage or you’re out shopping with a credit card.

In this type of high interest rate environment, there are a few important things for would-be borrowers to keep in mind when looking for financing options.

Prepare for Higher Monthly Payments

Higher interest rates generally mean higher monthly payments, unless you have a fixed-rate loan, like some mortgages and car loans. Interest rate fluctuations don’t affect these types of loans because the rate is set at the beginning of the loan and does not change throughout the effective term. But, if your loan has a variable rate, like an adjustable-rate mortgage, or you’re carrying a credit card balance, you will see your interest rates and monthly payments rise. You may need to review your budget to find ways to offset the higher cost of your debt. (Learn more about building a budget and sticking to it.)

Mind Your Debt-to-Income Ratio

Higher interest rates can also affect your debt-to-income (DTI) ratio — that is, how much of your monthly pre-tax income is used to pay down your debts. (Note that monthly rent is typically included in the calculation of your total debt, along with student and auto loan payments, mortgages, and minimum credit card payments.) As your interest rates and monthly payments go up, so does your total debt and thus your DTI ratio.

Your DTI ratio is an important indicator of your financial footing. A DTI ratio of 35% or less is generally considered healthy because it means you probably have money left to save or spend after paying your monthly bills and can likely manage unforeseen expenses. This gives you greater peace of mind, but it also signals to potential lenders that you are a less risky borrower. In fact, your DTI ratio is one of the key measures used by lenders to determine whether you qualify for financing. Most will reject your application if your DTI ratio rises above 50%; some won’t even consider you if it’s above 36%.

Keep a Long-Term Perspective

Banks and financial institutions are more likely to promote alternative loans or financing options when interest rates are high. Some of these products may be good cost-saving options, but it’s important to carefully consider their short- and long-term implications. If you’re house shopping, for example, you might be offered a temporary buydown. This type of mortgage allows you to make lower payments for the first 1-2 years in exchange for an upfront fee or a higher interest rate later in the loan term. You will save money initially, but borrowers typically end up paying a higher long-term interest rate and making larger monthly payments than they would have with a conventional mortgage.

Also, while it’s important to read the fine print on any loan or finance agreement, take particular care when reviewing alternative financing options. Some may not provide the same level of disclosure or consumer protection as traditional loans and credit products, and they may involve costly fees or other requirements that could affect your financial well-being.

Limit Your Borrowing

Conventional wisdom holds that if you don’t need a loan when interest rates are high, you should consider waiting to finance a new purchase. Focus on paying off your existing debt instead. Start with your high-interest debt, like credit cards. If you’re not in a position to pay off those debts, you can at least lower your balance and save some money on interest. You might shift your credit card debt to a zero-rate balance transfer credit card, for example, or consolidate your various debts under one low-rate personal loan.

A CFP® professional can help you make sense of these and other financing options if you find yourself in need of a loan amid this high interest rate environment. They can work with you to evaluate different loan and credit products and choose the best option for you. They can also make sure you have a repayment strategy in place before you commit to borrowing, so you can stay on track to meet your short- and long-term financial goals. Find CFP® professionals near you today using the “Find a CFP® professional” tool.