Last Chance to Minimize Interest Expense!

Want to improve cash flow and enhance profitability over the next 5, 10, even 20 years? Convert variable-rate debt to fixed? Look into refinancing fixed-rate debt that’s currently higher than 7 percent or so.

Have a line of credit that is never fully paid off? Consider taking out a term loan and using the proceeds to pay off the portion that doesn’t “revolve.” You may want to consider doing the same with credit card debt.^*

Interest rates remain at historic lows. Residential mortgage rates recently dipped to 5 percent. Interest burden is low today, but the reprieve won’t last. Rates will soon rise and before you know it, you’ll be paying 8, 9, even 10 percent on variable-rate debt. Don’t think it will happen? Look at the accompanying chart of historical rates — prime and residential mortgage. Yes, the future will reflect the past.

Weighted average rate of initial mortgage interest rates paid by home buyers on conventional fixed and adjustable rate mortgages.

Source: Mortgage-x.com

If you want more evidence that rates are poised to rise, listen to the comments of Ben Bernanke, U.S. Federal Reserve chairman. The Federal Reserve sets interest rates and Bernanke says they are going to hold rates at their current low levels until the economy is clearly out of the recession. He has said this for a couple of years now, and economic data show the economy is out of the recession. Gross domestic product (GDP) is growing again — a robust 3 percent (annualized) in the most recently reported quarter.

During periods of GDP growth, interest rates rise. During periods of low or negative GDP growth, interest rates decline. We’ve been through low, even negative, growth for a few years now. We’re now shifting to a period of interest rate increases.

Convert Variable Rate Debt to Fixed

If you currently have debt you pay a rate on that changes as the prime rate changes, talk to your lender about locking in a fixed rate. You might pay a slightly higher rate today, but you’ll be protected from rate increases and also know exactly what you’ll owe in interest and principal going forward, which helps for budgeting.

Credit card debt carried as variable-rate debt is at punishingly high rates. If you carry a balance on credit cards, talk to your banker about a loan to pay off your credit card(s) with a term loan (which has a fixed rate of interest).

Refinance Fixed-Rate Debt

If you have fixed-rate debt at a rate above 7 percent, talk to the bankers you know today about refinancing. The table on page 11 shows how the change in interest rates can affect annual interest expenses paid on a loan. Over the life of a loan, the interest rate impact is even more significant. For example, a 2-percentage-point interest savings on a $1 million, 25-year note is $390,000 over the life of the mortgage.

Again, if you don’t think we’ll ever see rates at 10 percent or greater, think again. History tends to repeat itself. Also, one way to deal with our federal debt problem is inflation.

Pay Attention to Terms

In evaluating loan options, there’s more to consider than the interest rate. Up-front expenses such as “points,” closing costs and even legal fees must be evaluated. The best method for comparing loans with varying terms is net present value (NPV). Review this article online to download a calculator (in Excel). It makes the job easy. The loan with the lowest NPV (all loans have a negative NPV) is the least expensive and therefore most attractive.

Effective Interest Rate

Another way to compare loans with varying terms is to calculate effective interest rates (EIR). It entails amortizing up-front costs over the life of the loan, i.e., adding the cost to the interest expense and recalculating the rate. Although this method is simple, it is not as desirable as NPV because it doesn’t take into account the time value of money. One thing that makes up-front costs so expensive is they’re due up front. Given a choice, you would rather pay in installments over the life of the loan. That’s what the effective interest rate calculation assumes, but not how it is in real life. So the EIR method understates the true cost of up-front fees. The NPV method does not. Still, EIR calculations are one way of viewing the cost of points and up-front fees.

The two tables display the effective rate calculations for various points paid on loans with 5-year and 25-year amortizations. One point is simply 1 percent of the loan value. So, for a $100,000 loan, two points is $2,000.

Comparing the two effective interest rate tables, you can see that up-front expenses have a far more substantial impact on short-term loans compared to long-term loans. When points are required to “buy down” an interest rate, doing so is far more attractive when the loan term is long.

Prepayment Penalties

Many loan terms include prepayment penalties. Calculating their effect can be tricky because they come into play only if you need to pay off the loan before its natural expiration date. This most often comes into play when interest rates fall and you wish to refinance. The chances of this happening to you on a loan you close today are slight, but you should consider this feature nonetheless. Comparing options to refinance involving a prepayment penalty, simply calculate the NPV of the existing note, using the calculator we provide online. Then calculate the NPV of the refinance option by entering the data for the new loan and include any prepayment penalty on the old note as an up-front expense on the new. Whichever option offers the lowest NPV is the most attractive (financially). Again, when using the Excel calculator, the loan with the lowest negative number is the least expensive.

^*Term loans require collateral and are therefore secured debt. Credit card debt is unsecured, of course, so you should take this into consideration before refinancing credit card debt with term debt.