This story is part of Recession Help Desk, CNET’s coverage of how to make smart money moves in an uncertain economy.
As surging mortgage rates reduce the demand for cash-out refinances, other types of financial products that allow you to tap into your home’s equity, like HELOCs and home equity loans, are growing in popularity.
Why it matters
Climbing rates will make borrowing more expensive for homeowners, but some loan types will be more affordable than others.
What it means for you
If you’ve built up equity in your home, HELOCs could be an affordable, flexible and safe way to tap into your money.
Due to rising home values during the pandemic, homeowners have record equity in their homes: Americans now have more than $18 trillion in aggregate home equity. Given economic turbulence, many are on the hunt for expedient ways to cash out on their home’s equity (the current market value minus what’s still owed on a mortgage loan).
Some experts expect to see a surge in demand for home equity lines of credit, or HELOCs. A HELOC is a loan that allows you to borrow against the equity you’ve built up in your home and functions almost like a credit card, allowing you to draw money over a period of years and make interest-only payments on what you borrow. Some use a HELOC for home improvement projects, while others might use it for a down payment on a second home, to start a business or even for an emergency fund.
For homeowners who locked in record-low mortgage rates during the pandemic, it likely won’t make sense to complete a cash-out refinance — when you replace your original mortgage with a new, more expensive mortgage at a lower interest rate and receive the difference as a lump sum — now that mortgage rates are more than 2% higher than they were at the beginning of this year. For example, if you recently locked in a 3% interest rate on your mortgage, a cash-out refi would put you at a disadvantage since current mortgage rates are in the low-to-mid 5% range. But with a HELOC, your original mortgage and interest rate will stay the same — you’re not refinancing, but simply taking out an additional loan.
HELOC rates increased after the Federal Reserve raised its benchmark interest rate for the fourth time this year in an attempt to combat inflation, and many experts expect HELOC rates to keep going up. “Every time the Fed raises rates, that filters through to HELOC borrowers, often within 60 to 90 days,” said Greg McBride, chief financial analyst at Bankrate, CNET’s sister site.
Nevertheless, a HELOC may remain a more strategic financial move over a cash-out refinance mainly because the principal loan amount is smaller. Read on to learn how the Fed influences HELOC rates, where rates are headed and why HELOCs don’t make sense for everyone.
How do HELOC rates compare?
The average HELOC rate for borrowers is currently 6.51%, according to Bankrate. HELOCs have come back in favor this year because borrowers who locked in historically low mortgage rates in 2020 and 2021 are reluctant to give up their lower rates through refinancing, as refi rates are currently hovering around 5.5%.
Unlike with a HELOC, with a cash-out refi you are taking on an entirely new mortgage that you pay off over the lifetime of the loan. With a HELOC, you are only borrowing a set amount of money that you can repeatedly draw down from over a set time period, usually 10 years, and which you must pay back in a certain amount of time, usually 20 years.
“Amid record high home prices, many homeowners have seen the value of their property increase, making HELOCs a potential option for tapping into equity,” said Robert Heck, VP of mortgage at Morty, an online mortgage marketplace.
Where are HELOC rates going?
It’s a safe assumption that HELOC rates will rise as the Federal Reserve continues to raise rates to control inflation through the end of the year. “The cumulative effect of the Fed rate hikes means HELOC borrowers are seeing rates ratchet higher and the rate you’re paying at the end of the year could be 3 or 3.5 percentage points higher than where you started the year,” said McBride.
The Federal Reserve’s latest rate hike of 0.75% in July was one of the largest rate hikes since 1994. “The Fed isn’t done raising interest rates and the only question is how much more they have to raise rates to quell inflation,” said McBride.
It’s important to keep in mind that HELOC rates are variable and rise and fall with interest rate trends overall, as well as the prime rate, which is the baseline interest rate banks use to determine lending rates. HELOCs are directly exposed to Fed interest rate hikes because their variable rates are pegged to the prime rate. As a borrower, you want to make sure you can afford the higher monthly payments that can come with a variable interest rate product like a HELOC.
“Something for borrowers with low promotional rates to be aware of is that rising interest rates may not impact you now while you have the low promotional rate, but they will most certainly impact the rate you pay when that promotional period expires,” said McBride. “Some borrowers are seeing their rates jump from 5% to 9.5% or 10% when their promotional rate expires.”
What are the risks of a HELOC?
Regardless of market conditions, it’s vital to understand that HELOCs come with an inherent risk of losing your home. Because your home is used as the collateral that secures your loan, if for any reason you default or can’t pay back your loan, the bank or lender can foreclose on your house in order to repay themselves. As such, it’s critical to make sure you can afford your monthly payments if your HELOC’s variable interest rate increases.
But there are ways to mitigate the risks. “See if your lender will fix the interest rate on your outstanding balance or consider refinancing your variable rate HELOC into a fixed rate home equity loan to shield yourself from further rate increases,” McBride said.
With a recession potentially looming, you’ll want to take stock of your overall financial scenario before locking into a HELOC. The stability of your employment and your assets and reserves can provide some security. In this moment of economic uncertainty, making sure you can cover your entire debt obligation should be your first priority — no matter where experts predict the market may be headed.
“Anyone considering a HELOC should do their research so they have a full understanding of the terms related to the loan, and evaluate their financial goals to ensure that a HELOC is the right way to access credit,” said Heck.