How to Restructure Your Debt in a Low-Interest Rate Environment

Many of us have a complicated relationship with debt. It’s something we’re afraid of getting too deep into yet in many cases, a necessity to afford large purchases or achieve certain milestones. Some of us will do everything in our power to get and stay out of debt. Others may lean on this route more than they should.

​Being in debt though is very different from managing debt and there are many ways to strike a healthy balance between your assets and liabilities. One of the best times to review, re-evaluate, and regain control of your debt is during a recession. When it feels like an economic crisis is wreaking havoc on everything around you, there is usually one silver lining - low interest rates. Leveraged properly, this can be your golden egg towards gaining financial sustainability.

This post will cover three ways in which you can consider restructuring your debt when interest rates are low:

1. Consolidate high-interest debt
2. Refinance your debt
3. Leverage new debt

Why do interest rates fall during an economic downturn?

​First off, let’s talk about how and why interest rates fluctuate with the economy. The key to getting a good interest rate on a debt obligation is knowing when to anticipate it. 

The Federal Reserve is a key player in regulating the economy and has two main goals:

• To minimize unemployment rates 
• To keep inflation rates under control (around 2%)

The Fed manages these conditions through a variety of tactics called monetary policy - i.e. printing money, buying or issuing bonds, and raising or lowering interest rates. 

When the economy slows down, households and businesses are less likely to borrow funds and take on additional debt. By lowering interest rates, the Fed hopes to encourage more borrowing and investing, thus injecting more liquidity into the economy. If economic growth accelerates too quickly though, the Fed may raise interest rates to reduce the risk of inflation.

Here you can see how the Federal Funds Rate dropped after 9/11, during the financial crisis, and currently through the COVID-19 pandemic. 

​Therefore, when an economic slowdown is on the horizon, it is a good time to be on the lookout for lower interest rates being offered on the market.
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Restructuring your debt in a low-interest rate environment

​In June 2020, the Federal Reserve confirmed that they do not intend to raise interest rates until 2022. This gives us reasonable confidence that loans will be available at attractive rates for the next couple of years. 
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Here are three ways you can take advantage of low-interest rates during this time frame and think about restructuring your debt. 

1. Consolidate high-interest debt

​One of the first places you should be tackling in a low-interest environment are any high-interest loans or lines of credit. If you do not have the means or funds to pay off these obligations in a short period of time, you can consider paying off this debt using a loan that offers a lower interest rate. Consolidating high-interest debt into a lower-interest loan is a great option to consider for short-term or smaller liabilities such as a credit card balance or a loan reaching the end of its term. 

There are several places you can look for a low-interest loan to consolidate and pay off high-interest debt. Below are a few options:

Personal Loan

If you are in good standing with your credit, a personal loan can be a great option to pay off high-interest debt. Personal loans are shorter-term loans offered by financial institutions that can be used for any purpose you choose. Borrowers receive a lump sum of cash that is paid off over a set number of years, typically 24-60 months, and pay interest on a monthly basis. 
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Borrowers with lower credit scores may still qualify for a personal loan, however, they may come with higher interest rates and fees that could negate the benefits of paying off high-interest debt. 

Interest rates for personal loans are particularly attractive right now, but they can also be an effective tactic during non-recessionary periods as well. Take a look at the spread between interest rates for personal loans and credit cards over time. Over the past few years, this gap has continued to widen, demonstrating the increasing value of leveraging a personal loan to consolidate high-interest debt. 
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​Secured Loan

Secured loans are loans that are backed by collateral that can be used as payment to the lender if you do not pay back the loan. If you own assets such as a home, investments, or whole life insurance, you may have the ability to take a loan against these assets at a favorable interest rate. Compared to unsecured loans like a personal loan, secured loans typically offer lower interest rates and are easier to obtain because they do not require a lengthy application or approval process. Since lenders assume less risk with a secure loan, borrowers with weaker credit may find it easier to qualify for this type of loan as well. 

Here are a few examples of secured loans. 

• Portfolio line of credit
• Home equity line of credit (HELOC) or home equity loan
• 401(K) loan
• Whole life insurance policy loan

While asset-backed loans can be an attractive option to consolidate high-interest debt, it is important to thoroughly review all of the terms and conditions first. If, for example, the value of your asset dips below a certain threshold, you may be required to repay a portion or the remainder of the loan within a short time frame to cover the loss. Putting your assets at risk can be much more damaging than paying a higher interest rate on your current debt, so be sure you have a clear understanding of the loan and a definitive repayment plan before moving ahead with this option. 
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Balance Transfer

A balance transfer allows you to move credit card debt from a high-interest credit card to a new card with a lower rate. Some credit cards will even offer an introductory period with a 0% APR. If you are trying to get out of credit card debt and can do so during the introductory period, a balance transfer can save a lot of money that you would have otherwise paid in interest.  

Bear in mind that there can be a balance transfer fee (typically 3%-5%) when making the switch. Additionally, interest rates may be higher than your original credit card once this introductory period is complete.  Therefore, if you plan on keeping a balance beyond this time frame, your effective interest rate may end up being higher in the long run. Make sure to map out a repayment plan first and crunch the numbers first to ensure a balance transfer will provide a cost savings to you. 
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2. Refinance a loan

Refinancing a loan is a good option for larger loans with a long term to maturity, such as a mortgage or auto loan. Refinancing a loan allows you to revise the terms of the loan, including the interest rate and time frame. When interest rates drop below your original terms, refinancing can potentially save you thousands of dollars over the life of the loan. 

Mortgage refinances are particularly attractive right now, hitting all-time lows in 2020. If you have not considered refinancing your home, this is a great opportunity to lower your interest payments. 

30-Year Mortgage Rates Over Time

​There are a few things you will want to keep in mind when considering a refinance:

• With heightened concerns around higher default rates during the pandemic, lenders are tightening up their standards for loan approvals. Therefore you are much more likely to be approved for a new loan if you are in good financial standing and have a solid credit score (760+). 
• When evaluating the cost-savings of a refinance, you will want to factor in the closing costs and extended term of the loan. For example, if you are 10 years into a 30-year loan and refinance to another 30-year loan, you have effectively extended the life of the loan an extra 10 years. 
• Closing costs can also be upwards of a few thousand dollars or more so you will want to factor in these fees in your cost-benefit analysis.

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3. Leverage low-interest debt

​If you have successfully minimized or eliminated your outstanding debt and are in good financial standing, you may want to think about strategies to leverage new debt in a low-interest rate environment. With interest rates at all-time lows, you have more purchasing power as well as the potential opportunity to pair low-interest debt with higher interest-earning, long-term investments. 

Let’s say for example you have the option to purchase a $100,000 home in cash or take out a 30-year mortgage of $80,000 at a 3.00% interest rate (assuming a 20% down payment of $20,000). 

Using a 30-year mortgage, the total principal plus interest you would pay for the home would be $141,422.55. 

Total Housing Cost = $20,000 (down payment) + $80,000 (principal) + $41,422.55 (interest)
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​Mortgage calculator courtesy of Vertex42. Click on image for link to full template.

​If, however, you take the $80,000 that you would have paid in cash toward the home and invested it in an asset that yields an average 5.00% compounded return annually over 30 years, your $80,000 investment would grow to $345,755. Therefore, even though you paid an additional $41,422 in interest for your home, you would still net out an extra $204,333 over the course of 30 years. Not bad!

A 5% compound growth rate for $80,000 over 30 years yields $345,755

​The lower the interest rates are, the greater opportunity you have to maximize the spread between your interest rate and the returns you can get through other long-term investments. Even though the economy may be suffering right now, markets will eventually rebound and grow in the long-run. Locking in a low interest rate now sets you up for greater financial gains in the future. 

Even if the numbers work out in your favor, always take into account your financial goals and peace of mind. If you are looking to grow your wealth in a strategic manner, leveraging low-interest debt may be worth the potential risks of investing your capital. If you are nearing retirement or financial independence though and are looking to protect your money, you may be better off reducing your liabilities and monthly debt obligations. 

Considerations when restructuring your debt

​Restructuring your debt in a low-interest environment can save you a lot of money in the long-run, however, it is important to factor in all of the terms, conditions, and fees when making changes to your liabilities. Putting your assets or overall financial standing at risk to reduce your liabilities may not always be the best trade-off.

 Here are a few questions you should be asking yourself before you make a move:

• What are new terms and conditions of the loan? 
• Will I be able to abide by these new terms and repayment schedule? 
• Will my credit history be negatively impacted?
• Am I putting any assets at undue risk? 
• Are there fees associated with changing or adjusting my loan? If so, do they justify a lower interest rate?
• Am I able to financially support a new debt obligation? 
• Am I losing any benefits by switching my current loan to a new one (ex: forgiveness, forbearance, deferral programs)?
• Will this impact my ability to fulfill other financial needs (loans, purchases, investments, etc.) in the future?
• Should I focus on improving my credit score or financial standing first to get the best rates on the market?​​

How to find competitive rates

​There are many online resources that you can use to search for competitive rates and find a lender. Here are a few free options I have personally used to compare rates in the past:
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• ​Bankrate
• Nerdwallet
• Credit Karma

You can also check with your bank or local credit union. If you currently have assets with a financial institution, you may be able to negotiate lower rates through relationship banking. 

Don’t let a good opportunity pass you by

​Although every economic cycle is different, recessions occur on average every 5 ½ years and last on average 18 months. Therefore, recessions are narrow windows of opportunity to leverage low interest rates when they come around. 

Given that the Fed is planning to keep interest rates low until 2022, there is a decent runway ahead of us to plan and restructure our debt. Even if the timing may not be right at this moment, it is a good time to think ahead about future purchases or debt obligations. Unlocking thousands of dollars can be a game changer in boosting your long-term wealth.

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