With interest rates high, a home equity loan or HELOC may be your best choice for cash right now.
In its December meeting, the Federal Reserve announced its third and final rate cut of 2024. Policymakers lowered the federal funds rate by 25 basis points to a range of 4.25% to 4.50%. While the reduction will bring borrowing costs down for many loan types, it may take some time for prospective homebuyers to see lower mortgage rates.
However, the decision may provide relief to other consumers. Borrowers with variable-rate loans, such as many HELOCs, are more likely to experience the effects of the change sooner than those with fixed-rate loans.
For most homeowners, home equity loans and home equity lines of credit (HELOC) are ways to access home equity.
In some cases, a cash-out refinance might be preferable when accessing the ownership value you have in your home. However, current mortgage rates are relatively high. About 84% of outstanding mortgages have a rate below 6.00%, so refinancing would likely result in a higher rate on the loan balance.
On the other hand, home equity loans and HELOCs allow homeowners in need of cash to keep the low rate on their first mortgage while borrowing from their home equity at the same time. New rates from the Federal Reserve will impact home equity and HELOC rates. Currently, the federal funds rate is set to a target range of 4.25% to 4.50%, with two cuts projected in 2025.
How do HELOCs and home equity loans work?
Home equity loans and HELOCs are tools for borrowing from your home equity, which represents your ownership in the property.
With a home equity loan, you borrow a lump sum from your equity, typically up to 80% to 90% of your home’s value, minus your mortgage balance. You can use the cash you receive however you wish, paying it back monthly with interest for 10 to 30 years. Home equity loans are sometimes called second mortgages, and paying one back will look and feel similar to repaying your original loan.
HELOCs work a little differently. You’re still borrowing from your equity and can use the money as you please, but you don’t get the funds you borrow in one lump sum. Instead, a HELOC functions more like a credit card. You access a line of credit you can pull from as needed. Repayment is different, too. With a HELOC, you’ll have a draw period, usually 10 years, during which you can access funds.
During the draw period on a HELOC, you usually only need to make interest payments on the money you use. After that, you enter the repayment period. For some HELOCs, this means making monthly payments for the next 20 years. For others, you may need to make a balloon payment, repaying the full amount you borrowed at once.
Who can use home equity products?
Lenders generally require that you maintain at least 20% equity in the home after taking out a home equity loan or HELOC. This means that your mortgage balance and your home equity loan balance combined can’t equal more than 80% of your home’s total value.
For example, if you had no existing mortgage, you could borrow up to $320,000 on a home worth $400,000. If you have a $100,000 balance on your first mortgage, you could borrow up to $220,000 with a HELOC or home equity loan.
Aside from having enough equity in your home, you need to meet other financial requirements. It varies by lender, but you usually need a credit score in the mid- to high-600s and a debt-to-income ratio (DTI) of 43% or less.
“Generally, a home equity loan or HELOC is great for folks who are working full time, have predictable income, can afford the additional monthly payment and have a credit score above 640,” says Jeff Levinsohn, CEO of equity tracking platform House Numbers. “If you’re paying off higher-interest debt with home equity, that helps you qualify. You’ll erase that monthly debt payment and often free up extra cash each month.”
Who should use a home equity product?
If you have substantial equity in your home and need to borrow a large amount, home equity products can be an attractive option compared to other financial products, such as credit cards or personal loans, which often have lower loan limits and higher rate.
“While personal loans of up to about $50,000 are fairly common, it’s harder to obtain them for larger amounts — and then, they often come with higher interest rates,” says Kyle Enright, president of mortgage at digital finance company Achieve. “With a home equity loan or HELOC — depending on the amount of equity you have in the home — much higher amounts are available.”
Home equity products might also have tax benefits. If you itemize your deduction and use the funds to “buy, build or substantially improve your house,” according to the IRS, you can deduct the interest you pay on the loan from your taxable income.
Should you get a home equity loan or a HELOC?
Both loan types let you use the equity in your home to meet your financial objectives. However, you should consider your needs and situation before deciding which to pursue.
If you know exactly how much you need to borrow, a home equity loan might meet your needs better than a HELOC. If you’re unsure of how much you need, or you plan access to money over an extended period (such as for college tuition or a home renovation, a HELOC might be preferable, as it will allow you to withdraw money as needed, up to your credit limit.
With a HELOC, you can repay what you’ve borrowed and withdraw more later, as long as you’re still within your draw period. You also only pay interest on what you borrow, allowing you to leave the credit line untouched unless you need it.
If you need lower payments for a shorter period of time, a HELOC may be a better fit. However, once you enter the repayment phase, payments can increase considerably, so it’s important to keep that in mind.
Whichever home equity product you choose, read the fine print to see if your HELOC requires a balloon payment or comes with variable interest rates. “A HELOC or home equity loan can be an excellent tool for financial wellness” if you’re prepared and fully understand the terms, says Alex Madonna, an executive at mortgage lender loanDepot.