Tiered Loans and Rising Rates

by Gary Foreman

Dear Dollar Stretcher,
I recently put a new furnace in my house and unfortunately I had to finance it. My payments have been $60 a month at 11.75 percent interest. I have never been late on a payment and usually I pay more than the minimum. Today I got a bill and my minimum payment went up to $80. I called the company to ask them why. They said that it was a tiered contract and since my balance went below a certain amount they raised my payment. They also said that since the government raised the prime rate they raised their rate. This makes me extremely irate. Have you ever heard of a tiered contract? I feel that this should be illegal. I will never get it paid off. I called the company and they told me there was nothing they could do. Any suggestions?
Dan K.

Like many others, Dan has found danger in the small print of a contract. And, based on the mail I get, he's not alone. More and more borrowers are finding surprises in their monthly bills.

What's happening here? Two things. The first is that loan agreements are more complicated now. Lenders realize that they can bury favorable terms into a contract. Most potential borrowers will never even bother to read the fine print. If they're surprised later, it's just too bad.

In Dan's case the loan agreement is written so that the minimum payment goes up as Dan's balance goes down. A tiered contract is perfectly legal. But the lender knew that most consumers think of the minimum monthly payment first. So it's very convenient to skip over the fact that a lower balance will eventually trigger a higher minimum payment. The lender also knew that the interest rate was tied to the prime rate. Technically, the government does not increase the "prime rate." The government controls the discount rate. That's the rate that they charge banks to borrow.

The banks pass along any increases by raising the prime rate. That's the rate that they charge to their "prime" customers. It's also used as the trigger for most variable rate loans. And that's where Dan comes in. He has discovered that rising interest rates can be tough on borrowers. And the trend in interest rates has been up. That means that the rate on any loan that's tied to the prime rate will go up. Simply put, it will take more money to pay off your loan.

A lot of people will join Dan and face higher bills. About one-third of all home mortgages are adjustable. Most credit card debt floats with the prime rate. The interest rate on variable home equity loans and lines of credit will also increase. So what can Dan do? Well, he can curse the furnace company, but it won't do him much good. The lawyers who wrote the contract almost certainly made sure that it met all necessary standards. And, if Dan signed it, the assumption is that he understood it.

The cold, hard facts are that the company can raise the interest rate and the minimum payment. Dan is obligated to honor the contract. Unless he can prove fraud or misrepresentation he's pretty much stuck. But, there are some things than Dan, and anyone else who has variable rate debt, can do to help minimize the pain. He's already taking the first step. That's prepaying variable rate debts. Any available money above the minimum due should go to the highest-rate variable debt that you owe.

The second step is more dramatic. It might be a good time for Dan to consider combining his variable-rate loans into one home equity loan. There are a number of possible advantages. First, even though the interest rate is still variable, it will probably be lower than he's paying now. Next, the interest could be deductible from his federal income taxes. That would also lower the cost.

If Dan does consolidate his loans he should talk to his mortgage holder and to the bank where he does his other business. Banks want to capture all of your business, so many will offer a rate that's a quarter of a percent lower to borrowers who already have checking accounts with them. The same is true for mortgage companies.

Before refinancing, Dan needs to consider his personality type. He'll have fewer checks to write each month. It's easy to feel wealthier at this point. And that could cause Dan to run up new debts. If he does he'll be making a critical mistake. It's also a good time to take a look at all of his expenses, to try to reduce spending and use the extra savings to pay off debt. Obviously if he owes less, any increase in rates will be less painful.

If he's consolidating under a homeowner's line of credit there's another reason to try to reduce the total indebtedness. Many lenders charge a higher rate of interest as your combined loans approach 100% of the value of your home. Less debt means a lower rate. Each lender is different so Dan will need to ask the lender where the rates change and what value they've put on his home.

Finally, we can all learn something from Dan's situation. First, much as we hate to do it, we need to read and understand any loan application that we sign. It's better to ask "dumb questions" now than to be irate later. We also need to look at any proposed borrowing and decide how high the payments could go. Would we be able to handle it if that occurred? Clearly Dan's options were limited if his furnace died. But it's possible that a more expensive model might have offered better financing arrangements if the contract were fully understood. The one bright light in Dan's situation is that his new furnace is probably more fuel-efficient than the old one. Given the increase in fuel prices, that's something to be thankful for this winter.

Gary Foreman

Gary Foreman is a former financial planner and purchasing manager who founded The Dollar Stretcher.com website and newsletters in 1996. He's been featured in MSN Money, Yahoo Finance, Fox Business, The Nightly Business Report, US News Money, Credit.com and CreditCards.com. Gary shares his philosophy of money here. You can follow Gary on Twitter. Gary is also available for audio, video or print interviews. For more info see his media page.

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