If you’re shopping for a home equity loan or home equity line of credit (HELOC), here’s some good news: Now that the Federal Reserve has begun to cut interest rates, home equity loan and HELOC rates are expected to decline.
Due to the dramatic surge in mortgage rates over the past few years, home equity lending has become an attractive alternative to cash-out refinancing.
“Home equity loans enable homeowners to tap into their equity without impacting the interest rate they have on their primary mortgage, which for most, is far below today’s current mortgage rates,” said Rob Cook, CMO at Discover Home Loans.
Whether you’re tapping into your home equity to consolidate debt or finance a large project, you should search for the best borrowing terms. However, it’s not totally in your control. Interest rates are impacted by several factors. Some are personal, like your credit score, but others are not, including the central bank’s decisions on monetary policy.
You don’t need to be an expert, but some basic knowledge can help you get the most out of your home equity.
Home equity loans vs. HELOCs
Home equity loans allow you to borrow money against your home to receive a lump sum of cash.
Home equity lines of credit act more like a credit card: You can draw the balance up or down to a certain limit rather than getting all the cash at once.
In both cases, you’ll need sufficient equity, measured as the difference between your mortgage debt and your home’s current market value. Both products act as second mortgages, using your home as collateral for the loan.
The role of the Fed and interest rates
As the central bank of the US, the Federal Reserve is “designed to help maintain economic stability,” said Jacob Channel, senior economist at LendingTree.
The Fed sets a benchmark interest rate, the federal funds rate, which affects the rate banks charge for all kinds of loan products, including home equity loans and HELOCs.
The Fed doesn’t set rates for home equity loans or lines of credit directly. The interest rates you see for home equity products will usually shift with the benchmark rate, which is why they’ve been exceptionally high in the last period.
After hiking the federal funds rate several times since 2022, the central bank is now reversing course to carry out rate reductions. So far, the Fed has reduced interest rates three times, most recently by 0.25% on Dec. 18.
The idea is this: High interest rates discourage people from spending and borrowing money, while low interest rates encourage it. In a weaker economy, the Fed would lower rates to boost economic activity. In a growing economy, the Fed would raise rates to guard against inflation.
Fed rate cuts make borrowing less expensive
If the Fed lowers its benchmark rate, banks will eventually decrease their rates for new home equity products, and vice versa, but “the relationship is not necessarily one to one,” Channel said. Other economic factors, like the job market, can also impact the rates set by banks.
There’s also a difference in how the Fed’s policy changes impact HELOCs versus home equity loans.
HELOCs: When the Fed cuts interest rates, homeowners with existing HELOCs and those looking to take out a new line of credit benefit. Home equity lines of credit typically have variable interest rates tied to the prime rate, which rises and falls with the federal funds rate. When the Fed makes rate cuts, it eventually trickles down to lower rates on existing HELOCs and those being offered by lenders.
Home equity loans: If you currently have a home equity loan, your interest rate won’t change with the Fed’s latest cut. With home equity loans, your rate will be fixed at the time you close on the loan, regardless of how the Fed adjusts rates down the road. Interest rates on new home equity loans, though, will reflect any policy changes by the Fed.
Channel expects that as the Fed carries out more rate cuts, it will translate to a gradual decline in rates across the economy, including for home equity loans and HELOCs, mortgages and cash-out refinance loans.
Why is the Fed cutting interest rates?
During the early days of the pandemic, when the economy came to a halt, the Fed lowered interest rates as much as possible. The idea was to encourage people to keep spending money during a weakened economy, and it motivated banks and lenders to set historically low mortgage rates, as low as 2% or 3%.
As the economy began to recover and inflation shot up, the Fed started raising interest rates to slow down price growth. The higher rates also led to increased rates for home equity loans. In 2021, home equity rates were as low as 4.4% and by the end of 2022, they were nearing 8%. Today, average home equity rates are in the mid-8% range.
As inflation started to cool consistently, the Fed began slashing interest rates. The goal is to adjust rates just enough so that inflation doesn’t reheat and unemployment doesn’t skyrocket.
Following its most recent rate cut, the central bank is likely to move cautiously, implementing occasional 0.25% reductions over the course of the coming year, depending on how the economy fares under the next administration.
Other factors impact home equity rates
The Fed’s benchmark interest rate is not the only thing that affects the rates you can get for a home equity loan or HELOC. Here are some other factors that can shift the rate you qualify for:
Your personal financial profile: Banks give their best rates to clients with high credit scores because it indicates they have a strong history of paying back debt on time. The lower your credit score, the higher your interest rate is likely to be. It also matters what other debts you have. If your mortgage is your only debt, you’ll probably get a better rate than if you’ve got lots of credit card or student loan debt, for example.
How much equity you have in your home: Lenders will typically allow you to borrow up to 80% or 90% of your home’s value. As an example, if your primary mortgage already amounts to 75% of your home value, banks will probably charge you a higher interest rate than if your mortgage only amounts to 40% of your home value, leaving lots of available equity to borrow against. Similarly, borrowing less of your available equity is one way to lower the potential interest rate on a home equity loan or HELOC.
Which bank or lender you use: Different lenders will offer varying rates, which is why it pays to shop around and get multiple quotes before you commit to a loan.
How to decide if you should tap into your home equity
If you’re set on leveraging your home equity sooner rather than later, taking out a new HELOC could be advantageous because its adjustable rate would likely go down as the Fed carries out more rate reductions. Just keep in mind that rates could also rise in the future based on the economic outlook, which means less predictability for your payments.
Depending on your personal goals and needs, you could take on a fixed-rate home equity loan a few months from now, when rates are likely to be lower. A home equity loan rate is fixed at the beginning, so you’d miss out on later rate drops, but you’d be insulated against any potential rate increases in the future.
If you’ve already borrowed against your home equity, the same principle applies: You could see your adjustable HELOC rate go down with the Fed rate reductions in the coming months, but a fixed home equity loan rate won’t change.
Fundamentally, how you leverage your home equity for financing hinges on why you need the money. If you’re using home equity to pay off higher-interest debts, like credit cards, then home equity rates now are already an improvement.
Even with a good rate, a home equity loan or HELOC always involves some risk. Both products are debts secured against your home, which means that if you default on payments, the bank can foreclose on your property.
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