An escrow account is used to set aside money to pay certain predetermined bills, which in our example household’s case are new tires, automobile insurance, taxes not withheld, vacation, veterinary bills, medications, and hay for horses (see figs. 2.4 A—C).
Explanation of items on worksheet:
New tires costing $850 will be purchased at the end of 2005. Saving $71 per month will reach that goal. ($850 ÷ 12 = $70.83)
Automobile insurance premiums totaling $1,800 annually are paid in $450 quarterly installments. $150 set aside per month is required. ($1,800 ÷ 12 = $150)
Taxes of approximately $600 are due April 15th. ($600 ÷ 12 = $50)
Vacation next January will cost approximately $1,950. A monthly savings of $165 should cover it. ($1,950 ÷ 12 = $162.50)
Veterinary costs for this household’s two horses average $1,200 per year. ($1200 ÷ 12 = $100)
Animal medications cost approximately $1,080 per year. ($1,080 ÷ 12 = $90)
Debt Management
According to the Federal Reserve (the Fed), the total amount of debt owed by consumers in the United States (credit card debt, car and personal loans—but not mortgages) has doubled in the last ten years, and toward the end of 2003 reached $2 trillion. At the same time, the nation’s savings rate has gone down considerably.
Explanation of items on worksheet:
Paid during the month of March: a $450 quarterly automobile insurance payment; the veterinarian ($100 for shots); and $180 worth of pet medications. The total of this household’s special bill-paying account at the end of March should be $1,998.
The Effect of Interest Rates
During 2003, the Federal Reserve reduced the benchmark federal funds rate♦ to the lowest level in over 45 years. As of December 2003, the funds rate was 1 percent, which many hoped to mean the continuance of lower interest rates on many types of loans for consumers and businesses. However, during 2004, the Fed started to tweak rates upward. Why? Because of a change in the demand for money. And, it seems forecasters and analysts are divided as to whether the economy may face a significant increase in inflation in 2006 and beyond. Further, there is a large federal budget deficit that appears as though it will continue to increase in the years to come. A budget deficit is a sign of instability in both individual business and government. It is viewed as a credit risk, and riskier borrowers are charged higher interest rates by lenders and investors. The federal deficit, therefore, sets the stage for future increases in interest rates.
SO YOU KNOW…
♦ The federal funds rate is the interest rate banks charge other banks for overnight loans.
Explanation of items on worksheet:
In April, this household paid $600 in taxes. The total in the account at the end of the month should be $2,099.
PRIME RATE FLUCTUATIONS
The economy is cyclical in nature. For example, during the Great Depression years (1933—1935), the prime rate♦ was approximately 1.5 percent. Below are some random time frames that show the fluctuation in the prime rate, according to the Federal Reserve:
| 1933-1935 | 1.5% |
| August 1956 | 4% |
| June 1969 | 8.5% |
| July 1974 | 12% |
| December 1976 | 6.25% |
| April 1980 | 20% |
| July 1981 | 20.5% |
| February 1989 | 11.5% |
| November 2001 | 5% |
| February 2005 | 5.5% |
These months represent highs and lows over the years. Between them, there were fluctuations. Rates steadily declined from 2001 until 2004, when it averaged 4 percent.
As interest rates again rise, households that have considerable consumer debt may very well be stressed. Their debt burden will increase and continue to grow as loans with variable interest (credit card loans, for example) cost more.
SO YOU KNOW…
♦ The prime rate is the interest rate banks charge their best (preferred) customers. Changes in the prime rate influence other rates, including mortgage rates.
Refinancing Your Mortgage
When 30-year mortgage rates are low (as they are at the time of writing), you should consider refinancing to “lock into” the lower rates and reduce your monthly payments. You can also refinance for more than the balance on your first mortgage in order to obtain cash to settle other debt, such as credit card loans. The interest on your mortgage is tax deductible, whereas interest on personal and automobile loans, for example, is not.
SO YOU KNOW…
♦ A home equity loan usually offers a fixed rate of interest and a payment schedule that matches a simple-interest amortization schedule (see p. 105).
♦ A home equity line usually offers a variable rate of interest and is a line of credit. It is similar to a credit card, the difference being that the loan is secured
