What Happens When Rates (Eventually) Rise?

In the wake of the S&P downgrade, the Federal Reserve announced yesterday that it would keep short-term interest rates near zero for two years. This was a departure from the Fed's previous language, which did not offer a specific timeline. These rock-bottom rates can't continue indefinitely, and the Fed has the power to raise them at any time. As well, further downgrades of the U.S. credit rating could work to push interest rates up. Overall, it seems reasonable to expect that rates will rise in the next several years -- even as the U.S. is still climbing out of hard economic times.

When this happens, what will be the cost to strapped consumers and to the government -- in the form of interest payments?

Credit Cards
American consumers, yoked to an average of $4,950 in credit card debt, are badly-positioned to withstand a rate hike. In the event that card rates rise, current balances won't be subject to the new rates. This is a result of a provision from the Credit Card Accountability, Responsibility, and Disclosure (CARD) Act of 2009, which: Bans rate increases on existing balances due to "any time, any reason" or "universal default" and severely restricts retroactive rate increases due to late payment.

However, new charges would not be exempt from the new rates, expected to be perhaps 2 to 3 percent higher than they are now.

Mortgages
Mortgage rates have in fact fallen as the 10-year has plummeted, but the Wall Street Journal reports that, as a result of the credit rating downgrade, they may yet snap back. If this occurs, a large swath of homeowners -- many of whom may not even be aware if they hold an ARM or a fixed rate -- will be hurt. The most vulnerable will be the holders of home equity loans, which, reports The Associated Press, "are almost always variable rate loans and typically adjust more frequently than first mortgages, sometimes even monthly."

The great majority of the country's new mortgages -- 90 percent of which are owned by Fannie Mae, Freddie Mac or Ginnie Mae -- may balloon if the government-owned entities are affected by the downgrade. As The Wall Street Journal notes, in the event of a downgrade, their borrowing costs will go up, and Fannie, Freddie and Ginnie will have to raise rates or suffer losses.

It should be noted that mortgage rates are generally tied to the yields on Treasurys, and so far, "there’s been little evidence" that investors consider Treasurys risky investments. If that changes, interest rates could rise.

Cities, Towns and States
Bad news:

Standard & Poor’s announced another wave of downgrades on Monday, lowering the credit ratings that affect thousands of cities, school districts, public housing and transportation projects directly linked to federal funds.

States and municipalities, especially those saddled with a sub par rating, will see their borrowing costs rise at a time when state finances are already shaky. New York, for example, may have to pay higher interests to borrow money. (A third of The Empire State's multi-billion dollar budget is derived from the federal government -- roughly the national average.)

The Federal Government
Despite a huge national debt, the United States now pays less interest on today (measured both as a percentage of GDP or a portion of federal spending) than it did in 1980, before the great borrowing binge began. Nobody expects these historic low rates to last; nor does anyone how high they might eventually go. But a scary study by the CBO in February found that if interest rates rise slightly more each year than CBO analysts now predict, that would increase U.S. borrowing costs by over $1 trillion during this period. Under the worst -- but not impossible -- scenario, borrowing costs could soar by $5.4 trillion.

No wonder U.S. officials had such a fit when S&P downgraded the U.S. credit rating.