In recent months, interest rates have jumped in many countries as commodities and other goods and service have also been increasing in price. The news in the past ten days has given borrowers some respite, at least in the US, where there was a cut. This story from the “UK Personal Loan Store” highlights the key points:

The US Federal Reserve decided to cut interest rates for the first time in four years, taking them down to 4.75% in an attempt to prevent a recession. Pressure had been on the “Fed” to cut rates from their level of 5.25% to make it easier for Americans to repay debts after the housing market in the US slowed down so much that a full-blown recession became a real possibility. The cut was needed to help underpin consumer spending.

Unfortunately, this news may ease short term concerns for many lenders, but rates were at all-time lows. The trend is only up, despite the ‘breather’ we’re going to be getting. In the UK, there are signs of a softening economy, and the likelihood that cuts will be cut somewhat.

But for many borrowers whose ARM mortgages will resetting at much higher rates in the near future, so these rate reductions that are going on will not take effect immediately, and may be short lived as the economy moves from near-recession to limited expansion.

So, what are some ways that you can limit the downside of rising interest rates on your mortgage payments? There are some obvious ways, if you have some extra cash in your bank or salary.

First, if your mortgage rates are rising, your savings rates should be, too. Make sure that you are getting better rates of interest on your savings as this will help to offset some of the extra payments you may have to make. While it is likely that your outstanding mortgage principal is still much greater than your savings, and your mortgage interest rate is most likely higher than your savings interest rate, it is still worth making the extra effort to make sure you don’t have too much cash in very low or no interest accounts, such as checking or accounts that you have forgotten to take care of.

Second, it might be wise to start paying down more of your mortgage balance than the minimum payments. There are lots of good calculators available on the Internet that can help you work out the effects of paying additional money. Of course, you will need to check carefully your loan agreement to make sure that the extra payments are not penalized or that paying off your mortgage too quickly attracts further penalties. Suffice to say, even an additional $100 or $200 paid off monthly can really cut the interest payments over the life of a 25- or 30-year mortgage.

I’ve done a little financial calculation to illustrate the point:

i. Let’s say you borrow $100K at 4.5% for 25 years. Over the term of the loan, you will repay the amount, plus the additional interest of nearly $66,750.

ii. Now, let’s say that your repay an additional $100 and $200 per month for the life of the loan. Same term, same interest rate. You will repay approximately $48,600 in interest, but your loan term will be about 19 years! At $200 per month, you will repay $38,420 in only 15.5 years. While it is true that you will save between $20,000 and $28,000, on your mortgage if the rate is fixed.

iii. Let’s assume that the rate jumps to 6%. How much will you save then? If your rate jumps to 6%, then you’ll end up paying over $93,000 in interest. But at $100 per month additional savings: you will pay approximately $66,250 (not saving very much there over the initial amount), BUT you WILL pay off the loan more than six years EARLY! At $200, though, you’ll pay about $51,900 and pay off the amount in about 15 years.

(Of course, there is a time at the other end of each term in ii. and iii. where you are no longer paying any mortgage at all. This extra money along with the mortgage payment can also be put into a bank account to attract additional income. That should help to reduce total interest paid over the original period of 25 years.

Third, you can pay additional lump sums to reduce the amount, using additional money that you’ve found, such as annual bonuses, and other occasional lump sums you may get. This will help to cut interest payments. An additional $1,000 per year would be a welcome addition to your mortgage.

Fourthly, you should go into your bank and renegotiate your mortgage. It’s a lot more work for a bank to attract a new customer than simply make an existing one happy, so you have ‘wiggle’ room on your mortgage, especially if you have proved a regular and trustworthy client. With house prices dropping, soon there is going to be a need to attract new business and generate new loans. Clients will become scarce, making existing loan clients that much more valuable. You could negotiate a different type of loan, a different type of repayment structure, or even a different amount, and perhaps most surprisingly, you may be able to negotiate the actual interest rate, especially with the smaller banks.

Whenever you look at your loan, you need to decide on a compromise between short term needs and long term goals. Obviously, everyone wants to pay as little as possible on a loan, but do make sure that your loan payments are affordable, and that amount of the mortgage loan is comfortable. Overstretching your budget is likely to be a problem that comes back and bites you. By and by, these points would apply equally well to anyone borrowing money for a personal loan or a secured loan, though the term and rates may be quite different.

I’d be happy to discuss these numbers or issues with any readers, but please understand I’m not an expert in mortgages, though I have successfully borrowed on several occasions to buy a house. I do however enjoy running numbers through my spreadsheet!

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