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Higher interest rates hold perils for borrowers, gains for savers

One homeowner in the Boston area will have $650 less spending money in the coming year. He has a $65,000 home equity loan with his interest rate linked to the prime. When the Federal Reserve Board boosted the discount rate by half a percentage point on Sept. 4, major banks raised the prime by the same amount. So this homeowner's next monthly loan bill will be $54.17 higher. A similar fate awaits those with adjustable-rate mortgages. They have at least until their next regular adjustment - which may be almost a year away - before they have to think about how much more they'll pay. But they are likely to pay more.

Then there are people who haven't bought homes yet. Two weeks ago, they may have qualified for a mortgage, when rates were about 10 percent. Today, with rates near or above 11 percent, some of them no longer qualify.

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On the other hand, investors in money market mutual funds and savers who put their money in bank accounts are rather pleased with recent developments. They've seen yields on their savings go up almost half a percentage point, with prospects for even greater increases in the weeks ahead.

The reception for the newest round of rising interest rates depends on which side of the equation you're on. The question now is: How much higher are rates going to go and how do you benefit from rate increases that can help and avoid getting pinched by those than can hurt?

``As [Fed chairman] Alan Greenspan continues to tighten monetary policy, interest rates will move up another one to two percentage points,'' says Michael Cosgrove, head of the Econoclast economic advisory service in Houston.

``You can't get away from the fact that interest rates are going to go up,'' says Richard Peach, senior economist at the Mortgage Bankers Association. ``Rates are likely to continue rising for the next 15 to 18 months.'' He expects the prevailing rate on 30-year fixed mortgages to reach 12 percent by the end of the year.

That's enough to make people reconsider adjustable-rate loans, even though the prospect for more rate increases could make the payments on those loans larger in the future. Still, ARMs, as they're called, are once again offering an attractive interest rate differential compared with fixed-rate mortgages.

``The spread between the 30-year fixed and the one-year ARM is nearly 3 points, compared with a spread of just 1.8 points in mid-March,'' says Robert Heady, publisher of Bank Rate Monitor, a newsletter in North Palm Beach, Fla. The average ARM is currently running about 7 percent. On an $80,000 mortgage, with a 30-year fixed rate at 11 percent, the monthly payments would be $762.40. The same loan with a one-year ARM at 7 would have payments of $616, plus taxes and insurance for both.

``At this point, the ARM looks relatively more attractive,'' Mr. Heady states.

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What is much less attractive now, of course, is the home equity loan. Since tax reform began eliminating the deductibility of most other types of loan interest, lenders have been aggressively pushing home equity loans for college bills, home improvements, even vacations.

Many consumer groups, however, have warned that a sudden recession or a spike in interest rates could set off a round of defaults or foreclosures. Whether this spike is that sharp remains to be seen, but it should serve as a warning of the built-in dangers of these loans.

``These loans probably won't be trumpeted while rates are moving up,'' says David L. Brown, senior vice-president at Florida National Bank in Jacksonville. They'd be trying to sell right into the teeth of these higher rates.''

Before signing up for one, ask the lender what your monthly payments would be if the prime were to go up one or two percentage points. The prime is now at 8 percent. Would your home be in danger if it went to 9, or 10 percent?

For savers, on the other hand, the recent news is somewhat better, although ``consumer savings rates tend to lag the open market rates,'' Mr. Brown says.

``We've seen increases in all types of interest rates over the last two or three weeks,'' says Robert Hays, product manager for deposits at First Wisconsin National Bank in Milwaukee. ``It really started before the discount rate went up.'' So far, at least, Mr. Hays has not seen a lot more people coming in to buy certificates of deposit. First Milwaukee is paying 6.77 percent for one-year CDs and 5 percent for money market deposit accounts. In more competitive markets, rates are even higher, which is why Bank Rate Monitor's national average for CDs is 7.08 percent.

Money market mutual funds, which offer a lower rate but easier access to your money, are yielding about 6.4 percent. That should increase, however, as portfolio managers roll over current investments into the new, higher-yielding paper that's coming along.

A key to getting the best return when rates are rising like this is to think short-term. Find a money fund that keeps its average maturity under 45 days.

If you prefer a bank or savings-and-loan, try to find one that compounds daily, instead of weekly, monthly, or annually. Then look for the highest-yielding money market deposit account or six-month CD you can. Locking your money up for even a year when rates are going up could mean missing the next rate boost - which may not be too far away.

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