The Federal Reserve’s interest rate decisions influence the rates you pay for variable-rate home equity lines of credit (HELOCs) and new home equity loans.
Fed officials announced on Mar. 20 that they will maintain the benchmark borrowing rate at its current 5.25 to 5.5 percent range. This is the fourth straight meeting where they’ve kept their target rate at this level — reiterating their stance that they will keep fighting inflation — amid increasing speculation among economists that rate cuts were coming soon.
“The Fed is not in a hurry to start cutting interest rates as the progress toward 2 percent inflation has encountered some turbulence,” says Greg McBride, CFA, Bankrate’s chief financial analyst.
Still, a decrease may yet happen this year. “The Fed left rates unchanged, as expected, but does expect that there will be three rate cuts in 2024,” says Melissa Cohn, regional vice president for William Raveis Mortgage, a full-service lender.
So what does that mean for home equity products? Let’s break down how the Fed’s monetary policy affects HELOCs and new home equity loans.
When the Fed alters the federal funds rate, the interest rate banks charge each other for overnight loans to meet reserve requirements, it has an impact on other benchmarks, such as the prime rate, which lenders charge their largest, most preferred clients. The prime normally runs three percentage points higher than the fed funds rate. When the federal funds rate rises or falls, the prime rate follows suit. Many lenders directly tie the rates on HELOCs and home equity loans to the prime rate, frequently adding additional percentage points, to determine the final rate you, the borrower, would pay.
The fact that the Fed maintained the status quo at its most recent meeting means that HELOCs will remain roughly the same in the short future. However, they have had a rough ride: According to Bankrate’s nationwide survey of lenders, the average HELOC interest rate will exceed ten percent in November 2023, the highest rate in more than two decades. To close out the month, HELOC rates have dropped to an average of 9.27 as on January 31. They, along with home equity loans, are expected to decline further in 2024.
With the Fed still planning to cut rates later in 2024, a HELOC may be more advantageous than a home equity loan because the rate may fall. In addition, with a HELOC, you can draw funds as needed and just pay interest on the funds you withdraw. So, if you don’t need the entire amount on your line of credit right away, you can take what you need now and wait for rates to lower before withdrawing more.
On the other hand, home equity loans typically have lower interest rates than HELOCs. According to Bankrate’s national survey of lenders, interest rates on HELOCs averaged 8.99 percent on March 20, while 15-year home equity loans averaged 8.7 percent.
What home equity borrowers should know about the Fed
Because HELOCs usually have variable interest rates, the cost of borrowing can rise or fall with the federal funds rate. If the fed funds rate goes up, your HELOC gets more expensive.
Home equity loans, on the other hand, come with fixed rates, so they aren’t as deeply impacted by the fed funds rate movement. Once you close the equity loan, your rate won’t change. But of course, the rate you get on a new loan reflects the fed funds rate activity and its impact on the prime rate.
If you want stability in your budget, know that with a HELOC, there’s no real way to predict whether rates will rise, fall or stay the same. Not only does your interest rate affect monthly costs; it can also greatly impact how much you pay for the line of credit overall.
Before you open a HELOC, understand the maximum interest rate, when the draw period ends and whether you’re responsible for interest payments only (or not) during this period.
If you already have a HELOC but don’t have a balance (in other words, haven’t drawn from it), rising rates won’t affect your wallet all that much. If you do owe, you’ll have a larger monthly payment to cover, usually within the next two billing cycles. This applies whether you’re in the draw or repayment phase.
With rates going up, you might want to explore whether you can lock in a fixed rate on a portion of your HELOC balance. This isn’t an option with every lender, and it might have some limitations if it is, however.
With the Fed’s current stance on taming inflation, rates could remain elevated until inflation falls within the Fed’s 2 percent benchmark.
“The decision about whether to take a home equity line of credit or a home equity loan depends more on the borrower’s need for the funds and purpose for borrowing than it does on interest rate, especially now that interest rates have peaked and are poised to start pulling back,” says McBride. So, if you have a pressing need for funds, now may be the time to take action. If you wait, interest rates could fall, but when and by how much remains to be seen.
The Federal Reserve’s interest rate decisions affect borrowing costs for many types of financial products, including home equity loans and lines of credit (HELOCs). When the Fed lowers its key rate, it causes the rates that lenders ultimately set for HELOCs and new home equity loans also to drop, and vice versa.
Read Also: HELOC Rate Predictions: Expert Insights for the Upcoming Year
At its meeting on Mar. 20, the Fed decided to maintain its key rate for the fifth meeting in a row. But the potential remains for interest cuts later in 2024 if inflation lessens. If you plan on taking out a home equity loan or — or already have a HELOC — keep an eye on how the rates attached to them change following a Fed announcement.
Home equity loan or HELOC: Which is better?
There’s no single answer. Depending on the Fed’s policy, where interest rates are heading and the nature of your financial need, one may be more ideal than the other.
HELOCs benefit most from rate decreases. With the Fed looking to lower rates later in 2024, a HELOC may be more beneficial than a home equity loan because the rate could go down. Also, with a HELOC, you can draw funds as you need them, and you only have to pay interest on the funds you actually take out. So, if you don’t need the full sum on your line of credit upfront, you can take what you need now and wait until rates drop to withdraw more.
On the other hand, home equity loans on average have lower interest rates than HELOCs. As of Mar. 20, interest rates on HELOCs average 8.99 percent, whereas 15-year home equity loans average 8.7 percent, according to Bankrate’s national survey of lenders.
If the Fed doesn’t move its fed funds rate significantly this year, fixed-rate home equity loans could maintain a lower rate than HELOCs. If you need a set large amount, a home equity loan will get you the funds with a predictable monthly payment. Plus, if rates fall by a large amount, you could always consider refinancing your HE loan, though you will likely need to pay closing costs.
“If you’re undertaking a home improvement project where costs will be incurred in stages, that is best suited to a home equity line of credit,” says McBride. “If you’re doing a debt consolidation where all the funds are disbursed at once, a fixed rate home equity loan may be the better choice.”
How the Federal Reserve Affects Mortgage Rates
The Federal Reserve influences mortgage rates, but it does not set them. At its March 20, 2024 meeting, the central bank held the federal funds rate steady and stated that it will monitor economic developments to determine its next rate decision.
Mortgage rates are influenced by a variety of factors, including inflation, job creation rate, and economic growth or contraction. The Federal Open Market Committee sets the Federal Reserve’s monetary policy, which is also an influence.
What the Federal Reserve does
The Federal Reserve is the nation’s central bank. It guides the economy with the twin goals of encouraging job growth while keeping inflation under control.
The FOMC pursues those goals through monetary policy: managing the supply of money and the cost of credit. Its main monetary policy tool is the federal funds rate, which is the interest rate that banks charge one another for short-term loans. Although there’s no such thing as “federal mortgage rates,” the federal funds rate influences interest rates for longer-term loans, including mortgages.
The FOMC meets eight times a year, roughly every six weeks, to tweak monetary policy. The Federal Reserve has maintained the federal funds rate in a range of 5.25% to 5.5% since July 2023. Its next meeting is April 30-May 1, 2024.
Central bankers have signaled that the Fed might pivot to cutting the federal funds rate this year, probably multiple times. Investors in interest rate markets expect the first in a series of rate cuts to happen in its June 11-12 meeting or the one after that, July 30-31.
The Federal Reserve, mortgage rates and inflation
Mortgage rates respond to many economic signals besides the federal funds rate. One major influence is inflation. The Fed’s goal is to maintain an inflation rate of around 2%. Inflation has been well above that for some time.
The consumer price index rose 0.4% from January to February, the Bureau of Labor Statistics announced on March 12, to an annual rate of 3.2%. The core CPI, which excludes food and energy prices, was up 0.4% for the month. At a rate of 3.8% for the year, it was one-tenth of a percentage point higher than the industry forecast.
Although these numbers are higher than the Fed wants, the inflation rate has been falling and seemingly is on the way to the Fed’s 2% target. As a result, the Fed is expected to cut the federal funds rate this spring.
The availability of jobs also influences monetary policy. When the economy is creating lots of jobs, it means the economy is growing — a situation that tends to push the inflation rate higher. The Fed responds by raising interest rates. When job creation slows down, or when many people lose their jobs, inflation tends to fall. The Fed responds by cutting interest rates.
In the past few months, the economy has been in an in-between place, in which the inflation rate is high, but falling, while job creation and consumer spending remain fairly strong. The overall state of the economy creates ambiguity surrounding what the Fed should and will do next.
Do mortgage rates follow Fed rates?
The Fed and the mortgage market move like dance partners: Sometimes the Fed leads, sometimes the mortgage market leads, and sometimes they dance on their own. The federal funds rate and mortgage rates usually move in the same direction. But it’s sometimes hard to say whether mortgage rates follow the Fed’s actions or the other way around.
The FOMC prefers to give investors a heads-up whenever it plans to raise or cut short-term interest rates. Members of the committee advertise their intentions by sprinkling hints into their public speeches. By the time the committee meets, there’s usually a consensus among investors as to whether the Fed will cut rates, raise them or keep them unchanged.
As that consensus solidifies before an FOMC meeting, mortgage rates usually drift in the direction that the Fed is expected to move. Often, by the time of the meeting, mortgage rates already reflect the expected rate change.
At the same time, mortgage rates move up and down daily in reaction to the ebb and flow of the U.S. and global economies, which are the same developments that the Fed responds to.
Federal funds rate and HELOCs
Although there’s merely an indirect link between mortgage rates and the federal funds rate, the Fed does have a direct influence on the rates charged on home equity lines of credit, which typically have adjustable rates.
Interest rates on HELOCs are linked to the Wall Street Journal prime rate, which is the base rate on corporate loans by the largest banks. The prime rate, in turn, moves with the federal funds rate. The prime rate is 8.5%.
| Current prime rate | Prime rate last week | Prime rate in the past year — low | Prime rate in the past year — high |
|---|---|---|---|
| 8.50%. | 8.50%. | 8.0%. | 8.50%. |
HELOC and Home Equity Loan Requirements in 2024
One of the primary advantages of homeownership is the potential to accumulate equity. When you’ve saved enough money by paying down your mortgage, you can use it to get a home equity loan or a home equity line of credit. The following are the eligibility requirements for each of these funding alternatives in 2024.
Both HELOCs and home equity loans allow you to borrow money based on the equity you have in your home. Here is a quick comparison between the two:
| HELOC | Home Equity Loan | |
|---|---|---|
| Overview | A variable line of credit with a typical draw period of 5-10 years when you can pull out funds as needed | A loan for a fixed amount, delivered in a lump sum |
| Rates | Variable | Fixed |
| Terms | Up to 30 years (10-year draw period, 20-year repayment period) | 5-30 years |
| Repayment | Up to 20 years | Up to 30 years |
| Monthly payments | Interest-only during draw period, then principal and interest during repayment period | Principal and interest payments during repayment period |
| Benefits | Borrow only what you need Lower rates compared to credit cards Potential to deduct interest | Fixed monthly payments Potential to deduct interest |
| Drawbacks | Home is collateral Variable monthly payments Some fees | Home is collateral Closing costs |
Regardless of which type of loan you choose, home equity loan requirements and HELOC requirements tend to follow these standards:
- A minimum percentage of equity in your home
- Good credit
- Low debt-to-income (DTI) ratio
- Sufficient income
- Reliable payment history
At least 20 percent equity in your home
Equity is the difference between how much you owe on your mortgage and your home’s value. This determines your loan-to-value ratio, or LTV.
To find your LTV, divide your current mortgage balance by your home’s appraised value. If your loan balance is $150,000, for example, and an appraiser values your home at $450,000, you would divide the balance by the appraisal for an LTV ratio of about 33 percent. This means you have 67 percent equity in your home.
When you apply this ratio to both your first mortgage and the HELOC or home equity loan, you get the combined loan-to-value (CLTV) ratio. This is the figure lenders use to determine how much equity you could be eligible to tap. Most lenders require you to maintain a minimum of 20 percent equity (although some allow 15 percent).
Using the example above, say you’d like to take out a home equity loan for $30,000. Your combined balances would equal $180,000 ($150,000 first mortgage + $30,000 home equity loan). This translates to a 40 percent CLTV ratio ($180,000 / $450,000), which is under the lender’s 80 percent maximum.
Credit score in mid-600s
Many lenders allow you to tap your equity with a credit score in the 600s (680 once was common, but the norm is now closer to 620, especially for HELOCs). You won’t get the best rate with a lower score, however.
Some lenders also extend loans to those with scores below 620, but these lenders might require you to have more equity or carry less debt relative to your income. Bad credit home equity loans and HELOCs could come with higher interest rates, limited loan amounts and shorter repayment periods.
Before applying for a home equity product, take steps to maintain or improve your credit score. This involves making timely payments on loans or credit cards, paying off as much debt as possible and avoiding new credit applications.
DTI ratio of 43 percent or less
The debt-to-income (DTI) ratio is a measure of your gross monthly income relative to your monthly debt payments, including your mortgage and home equity loan payments. Qualifying DTI ratios can vary from lender to lender, but, in general, the lower your DTI, the better. Most home equity lenders look for a DTI ratio of no more than 43 percent.
To calculate your DTI ratio, divide your total monthly debt payments by your gross monthly income, then multiply that result by 100 to get a percentage. If that percentage exceeds 43 percent (or whatever your lender’s specific threshold is), you have a few options: You can work to pay off as much debt as you can; increase your income; or lower the loan amount.
Adequate income
There isn’t a set income requirement for a HELOC or home equity loan, but you do need to earn enough to meet the DTI ratio requirement for the amount of money you’re hoping to tap. You’ll also need to prove that you have income consistently coming in.
Be prepared to provide income verification information when you apply for your loan, such as W-2s and paystubs.
