What Do Falling Rates Mean for Your Debt?

With the Federal Reserve's benchmark federal funds rate now at its lowest level since mid-2022, it's not surprising to see headlines asking whether it's time for borrowers to refinance or consolidate their debt.

The reality, however, is that recent rate cuts may not benefit all borrowers equally, and some moves might actually increase borrowers' costs and risk. The lowest possible interest rates are typically available only to those with very good credit and/or substantial assets to support their borrowing plans. In contrast, the interest rates available to those with less-than-perfect credit could remain stubbornly high.

It's also important to keep in mind that loans aren't all the same and shouldn't be treated in the same way. What you use a line of credit for—and how—matters.

To illustrate, we'll look at four hypothetical borrowing scenarios involving various forms of debt and borrowers with different credit profiles.

Michael, 35, lost his job during the COVID-19 pandemic and racked up credit card debt to cover his living expenses while he looked for new employment. He eventually landed a position but still has high-cost revolving balances on several cards, totaling about $20,000. Michael owns his home and recently opened a HELOC, which he's considering using to consolidate his credit card debt at a lower rate.

Potential solutions: Two factors argue against using a HELOC in this way. First, Michael would be using his home as collateral for what was previously unsecured debt. Putting his home up as collateral is a risk: Failure to make HELOC payments could ultimately lead to the lender seizing his house. And, second, consolidating with a HELOC, even at a lower rate, could lead him to pay more interest if he takes his time to pay off the HELOC (up to 10 years of interest-only payments during the "draw" period and typically 20 years in the repayment period).

So, rather than consolidating with a HELOC, Michael could first consider stabilizing his situation by not adding more to his credit cards. Then, he should consider a debt repayment strategy to pay off his debts:

• Consolidate his various credit card debts under fewer cards or with an unsecured personal loan from his bank or credit card company (assuming the fees and total interest paid yield some savings).
• Stick to a payoff strategy with his current credit cards. There are a few ways to do this. For example, he could go for the "snowball method" of targeting the smallest balance first and paying as much as he can each month (while continuing to pay the minimum payments on all other cards). Once he zeros out the smallest balance, he would roll that payment into the next smallest debt, and so on, until everything is paid off. Conversely, he could try the "avalanche method" of paying down the debts with the highest interest rates first while making minimum payments on all other debts.

As a secondary objective, income permitting, Michael could also build up his emergency savings so he doesn't have to rely on credit cards or other borrowing to cover unexpected expenses in the future.

If Michael doesn't have sufficient income to pay off his debt, he may need to consider a debt management plan—a structured repayment arrangement, usually established through a credit counseling agency, that combines multiple unsecured debts into one affordable monthly payment at a lower, negotiated rate. This tactic could lead to a temporary dip in his credit score, but it's likely to recover so long as he makes all his payments on time.

Sally is a 28-year-old who still owes about $50,000 in federal student debt, along with another $50,000 from two personal loans she and her husband took out to pay for their wedding and furnish their new home. They both have solid credit and are considering consolidating all three loans into a lower-rate option.

Potential solutions: Sally may want to keep her federal student loans separate. Federal student loans offer favorable provisions like income-sensitive repayment plans, deferral opportunities, forbearance, or forgiveness. Qualified student loan interest may also be tax-deductible. If she consolidated her student loan debt with her other personal debt, she would lose access to these benefits. So, if Sally had multiple student loans, she could combine them into a federal consolidated student loan. That would make repayments easier, and she would still retain access to the potential benefits available to student loan holders.

Then, she could consolidate her personal loans separately. A new, lower-cost personal loan might be available to her now that interest rates are a bit lower and could simplify her monthly payments. However, she should also pay close attention to any related fees, such as origination fees on the new loan or prepayment penalties on the existing ones.

Tim, a self-employed 50-year-old with sizable brokerage assets and great credit, recently had surgery and is facing out-of-pocket bills and related costs of $20,000 after insurance.

Potential solutions: The best-case scenario would be if Tim had either a well-funded health savings account or a sufficient emergency fund to cover these unexpected costs. Lacking these, his assets and good credit could give him access to some potential options:

• He could ask if the hospital offers an interest-free payment plan or discounted interest rate for highly qualified borrowers.
• He could liquidate some of his brokerage assets to pay the obligation (and avoid paying interest at all)—particularly if he can negotiate some of the medical costs down. Doing so could potentially result in capital gains taxes, but he might be able to offset these by harvesting some of his losses.
• Liquidation isn't the only way to leverage brokerage assets. Tim could also consider using his portfolio to open a pledged asset line (PAL)—a flexible line of credit backed by nonretirement assets—which may have a lower interest rate than that offered by the hospital payment plan, especially now that prevailing rates are declining. This route could be helpful if Tim prefers not to sell his assets. That would allow him to avoid any potential tax consequences and keep his assets invested in the markets (especially if he can generate returns that are higher than what he'd pay in interest).

The bottom line is that Tim's good credit and substantial assets give him more options.

There's also the medical tax deduction to consider: If his qualified medical expenses exceed 7.5% of his taxable income for the year, the excess amount over 7.5% may be tax-deductible (if he itemizes). The deduction could reduce his overall cost whether he decides to pay it in full or finance it.

Sheila, a 45-year-old homeowner with good credit and a HELOC, has a 5.5% auto loan from a dealer on an SUV she bought two years ago. Recently, she replaced her home's heat pump using special financing through the HVAC company that has a 0% introductory rate for 12 months and a variable rate—currently 21%—thereafter.

Potential solutions: If Sheila can refinance her auto loan at a lower interest rate for the same or shorter term with minimal fees, that may be worth considering. However, if the lower interest rate comes with an extended loan term, she may want to consider paying her current car loan on schedule. Cars depreciate quickly, and the new loan could outlast the vehicle's value.

The heat pump is a different calculation. If possible, Sheila could aim to pay off the full cost of the heat pump during the 0% introductory period, resulting in zero borrowing costs. If she needs more time, after the introductory period, she could transfer the remaining balance to her HELOC, likely at a lower interest rate than the HVAC loan after the introductory period.

Managing debt wisely means regularly monitoring your situation for potential savings, as even small reductions in your borrowing rates can add up over time due to the compounding effect of interest. But lower rates aren't always a reason to refinance or consolidate your debt, and in some cases can even increase your overall costs or put your most valuable assets—like your home or investments—at risk.