Housing & Mortgage
How to Tap Home Equity as Interest Rates Rise
Most home equity lines of credit have variable rates; a hybrid HELOC offers the chance to convert to a fixed rate
Renovating the kitchen, tricking out the bathroom or creating a relationship-saving man cave or she shed is now more doable than at any time since the financial crisis. Rising home values have pushed up our collective home equity, which is the value of our lairs minus the mortgage balance.
And we’re increasingly eager to scratch our upgrade itch. Homeowners are expected to shell out more than $350 billion for remodeling projects in the 12 months through September 2019, a 30% rise in just three years.
There are two ways to tap home equity. A classic home equity loan (HEL) is a standard fixed-rate loan. You get a chunk of money upfront, and then pay it back over a set period of time of five to 10 years, or longer.
For years, home equity lines of credit (HELOCs) have been far more popular than HELs. A HELOC works a lot like a credit card: You have a credit limit you can borrow against (typically for 10 years), and any time you pay back any money, you regain borrowing capacity. The interest rate on HELOCs is variable, not fixed.
HELOCs have become even more popular since the financial crisis, as a change in lender regulations makes it more expensive for lenders to offer HELs.
Yet for the first time since the financial crisis, a variable-rate HELOC now packs some interest rate risk.
It’s important to understand that the Federal Reserve is pulling the strings behind the curtain of HELOC rates. The Fed determines the trajectory of short-term interest rates through its Federal Funds rate. And most HELOC interest rates are based on a formula that starts with the Fed Funds rate (or other short-term rate indexes) and then adds a few percentage points of “margin.”
From 2008 through most of 2015, the Federal Reserve kept the Federal Funds rate near zero, as a way to encourage more economic growth coming out of the financial crisis. That made HELOCs a screaming deal, with rates as low as 3% or so.
But with signs that the economy is in fact doing much better, the Fed has been slowly raising its target interest rate from the abnormal zero level. The Fed Funds rate is now above 2%. Rate-watching experts give a high probability that by the fall of 2019, the Fed Funds rate will be in the vicinity of 2.5%.
That means that if you use a HELOC with a variable interest rate, you may likely be setting yourself up for higher rates, and higher payments, in the future.
For a big renovation project that you expect to need three, five or even 10 years to pay back, locking in the fixed rate of a classic HEL could be a financially smart move for the longer-term; it’ll also give you peace of mind that you won’t have any payment shocks in the future. Many credit unions continue to offer home equity loans.
A $50,000 draw on a HELOC that you take 10 years to pay back will run you about $555 a month at today’s 6% average rate. If the rate rises to 7%, you’re looking at a payment of $580. If rates creep higher, so too will your HELOC tab. (You can run the numbers using different rate assumptions.) Opt for a HEL and at today’s average 6.4% interest rate you can lock in a monthly payment of around $565, which won’t budge over the life of a 10-year payback.
Another option is to consider a newer twist in home equity borrowing: a hybrid HELOC that gives you the option of converting from the variable rate to a fixed rate. Just be sure you understand when you can convert and what your fixed rate will be. The fixed rate will obviously be higher than the variable. The peace of mind may be worth it, especially if you expect to take many years – not months – to repay the line.