The Federal Reserve’s interest rate decisions affect the payment you’ll get on an adjustable-rate mortgage-backed line of credit (HELOC) or new mortgage, which of course depends on your own financial situation and is not up to you personally, but rather on the offers advertised by lenders and general interest rate trends.
But how? Let’s analyze how the Federal Reserve’s monetary policy, announced at regular meetings throughout the year, affects the cost of borrowing against the equity of your home.
How do Fed interest rates affect HELOCs?
When the Federal Reserve changes the federal funds rate (the interest rate banks charge on overnight loans to meet reserve requirements), it also affects other benchmarks (the interest rates lenders charge their largest and most favored customers). The prime rate is typically 3 percentage points higher than the federal funds rate. As the federal funds rate changes, the prime rate moves up and down in tandem. Many lenders tie interest rates on HELOCs and home equity loans directly to the prime rate, often adding an additional percentage point to determine the final interest rate you, the borrower, pay.
The Federal Reserve is finally starting to cut interest rates (see box), which means HELOCs could fall in the short term. But HELOCs have had a bumpy road. In November 2023, the average HELOC interest rate topped 10%, the highest HELOC rate in the past 20 years, according to Bankrate’s national lender survey. But they fell back into the single digits in the new year. And, along with home equity loans, they’re expected to fall even further in 2024.
Federal Reserve’s latest meeting
The Federal Reserve cut interest rates by a half-point at its Sept. 17-18 meeting, the first adjustment since July 2023. “This recalibration of our policy stance will help maintain strength in the economy and labor market and allow inflation to move further forward as we begin the process of moving to a more neutral stance,” Fed Chairman Jerome Powell said in a statement after the meeting. “We are not on a preset course and will continue to make decisions at each meeting.”
Greg McBride, CFA, chief financial analyst at Bankrate, emphasizes that the Fed is cutting rates to ease interest rate constraints, not to jumpstart the economy. “If the Fed gets the balance right, this bodes well for continued economic expansion and low unemployment. Move too quickly and inflationary pressures could return, move too slowly and the economy could stall and slip into recession,” he says.
What mortgage borrowers need to know about the Fed
HELOCs usually have variable interest rates, meaning that your borrowing costs go up and down with the federal funds rate. When the federal funds rate goes up, your HELOC costs more. When the federal funds rate goes down, your HELOC costs less.
On the other hand, home equity loans have a fixed interest rate, so they are not as affected by fluctuations in the federal funds rate. Once you pay off your mortgage, your interest rate stays the same. But, of course, the interest rate on a new loan will reflect changes in the federal funds rate and how that affects the prime interest rate.
If you’re looking to stabilize your budget, know that with a HELOC, there’s no realistic way to predict whether your interest rate will go up, go down, or stay the same. Interest rates not only affect your monthly costs, but they also greatly affect the amount you pay towards your overall line of credit.
Before you open a HELOC, make sure you understand the maximum interest rate, when the drawdown period ends, and whether or not you’ll be responsible for interest-only payments during this period (or not).
If you already have a HELOC but don’t have a balance (i.e., you haven’t drawn down on it), the increase in interest rates won’t hit you as hard in the wallet. If you owe on it, you’ll usually see an increase in your monthly payment over the next two billing cycles. This applies whether you’re in the drawdown or repayment phase.
If interest rates rise, consider whether you can lock in a fixed interest rate on a portion of your HELOC balance. This isn’t an option available with all lenders, and even if it is available, there may be limitations.
But overall, “creating a debt repayment plan is the best way to mitigate the impact of high HELOC interest rates,” advises McBride.
Home Equity Loan or HELOC: Which is Better?
There’s no one answer: one may be more ideal than the other, depending on Fed policy, interest rate movements, and the nature of your financial needs.
HELOCs benefit the most from falling interest rates. The Fed is set to cut interest rates in 2024, and interest rates could fall dramatically, making a HELOC more advantageous than a home equity loan. A HELOC also allows you to withdraw funds when you need them, and you only have to pay interest on the funds you actually withdraw. So if you don’t need to pay the full amount of your line of credit up front, you can withdraw only what you need now and wait until interest rates drop before you can withdraw more.
On the other hand, home equity loans tend to have lower interest rates than HELOCs. As of Sept. 18, the average interest rate for a HELOC was 9.26%, while the average interest rate for a 15-year home equity loan was 8.49%, according to Bankrate’s national lender survey.
If you need a set amount of money, a mortgage can help you raise funds with predictable monthly payments, and if interest rates drop significantly, you could consider refinancing your HE loan, though you’ll likely have to pay settlement costs.
“If you’re embarking on a home improvement project where the costs will be incurred in stages, a home equity line of credit is a great choice,” says McBride. “If you’re doing a debt consolidation where all the funds are paid at once, a fixed-rate home equity loan may be a better choice.”
Is now a good time to take out a mortgage or HELOC?
With inflation growing much closer to the Fed’s 2% benchmark, interest rates on HELOCs and home equity loans could fall in the near term.
“The decision to choose between a mortgage-backed line of credit or a mortgage-secured loan depends more on the borrower’s financial needs and borrowing objectives than on interest rates, especially now that interest rates have peaked and are starting to be reduced,” says McBride. So if you’re in urgent need of funds, now may be the time to act. Waiting could bring interest rates down, but it’s still unclear when and by how much.
Conclusion: The Fed’s impact on HELOCs and home equity loans
The Federal Reserve’s interest rate decisions affect the cost of borrowing for many types of financial products, including mortgages and lines of credit (HELOCs). When the Federal Reserve lowers its prime interest rates, the interest rates that lenders ultimately charge on HELOCs and new mortgages also fall, and vice versa.
If you’re planning on taking out a mortgage or already have a mortgage-backed loan, keep an eye on how interest rates react following the Fed’s announcement.
