Is Your HELOC Getting More Expensive?
If you currently have a home equity line of credit, or a HELOC, or thinking about applying for one, you should note that HELOC rates will rise as rates in general do. A HELOC is in fact a line of credit secured by real estate. The interest rates assigned to a HELOC are adjustable versus a fixed rate and can rise and fall as the result of actions taken by the Federal Reserve Board. Just last December, the Fed raised the Federal Funds rate by 0.25%, a similar increase from one year before. Recently, Fed Chair Janet Yellen commented we should expect three such increases in 2017 alone. That in turn will increase rates overall.
The Federal Reserve Board has a primary task which is helping to regulate the cost of money, doing so by adjusting key interest rates. The rate the Fed has a direct connection to is the Federal Funds rate. The Fed Funds rate is the rate banks charge one another for short term loans, as in “overnight” loans. Banks borrow from one another to meet federally mandated liquid reserve requirements.
The Fed adjusts interest rate in reaction to and in anticipation of economic data. When the economy appears to be strengthening the Fed may increase interest rates to head off any inflation associated with a strong economy. As consumers demand more goods and services prices go up and the dollar is worth less than it was before the price increase. When an economy is in the doldrums, the Fed can lower rates in an effort to increase spending, capital improvements and encourage banks to issue more loans.
The Prime Rate
The Prime Rate referred to is the one tracked by the Wall Street Journal. The prime rate is the average rate that 20-25 of the largest banks in the country charge its best corporate borrowers. The prime rate is directly affected by the Federal Funds rate and is 300 basis points higher. If for example the Federal Funds rate is set at 0.75% the prime rate is 3.75%. Last November for instance and prior to the most recent rate increase, the prime rate was 3.50% as the Fed Funds rate was pegged at 0.50%.
If the Fed does in fact raise the Federal Funds rate with three separate 0.25% moves that would put the Federal Funds rate at 1.50% by the end of the year. The prime rate would then be 3.00% above that number or 4.50%. HELOCs can have the prime rate as its index and when the prime rate goes up, so too do the interest rates on HELOCs.
Adjustable rate mortgages, ARMs, are comprised of three separate components, an index, margin and caps. A HELOC uses an ARM when calculating a monthly payment. The rate is based upon the outstanding balance, if any, on the HELOC. If the index is the prime rate the lender adds a margin to it. If the margin were say 2.00% and the index 3.75% the new rate would then be 5.75% on the amount borrowed.
Caps make sure there are no wild swings at the next adjustment period. A common cap is 1.00 or 2.00% over the previous rate. In this example, even if the prime rate hit 10.00% even though the new rate wanted to hit 12.00% if the cap were 2.00% and the previous HELOC rate 5.75% the most it would go to would be 7.75%.
If you want to keep your HELOC and continue to use the revolving credit line over time there really is little you can do other than bearing future rate increases. But if you do want to stave off higher payments you’ll either need to pay off any current balance or cancel the HELOC altogether.
But there’s also a third option- refinancing. For example, let’s say you have a HELOC with a credit line of $50,000 and there is a $20,000 balance. You can convert part of the equity line into a fixed rate and in this instance you could convert $20,000 into a fixed and avoiding future rate increases. Doing so however reduces your available revolving credit.
Or, if you’re considering or currently in the process of refinancing your first lien mortgage you could pull out some additional cash during the transaction to pay off the $20,000 balance and roll that amount into the newly refinanced loan. The lowest rates available are those reserved for owner-occupied real estate when the lien is in the first position.
If none of these options sound attractive then there really is nothing more you can do to avoid future rate increases other than keeping the HELOC balance as low as possible and access the funds only when really needed. Even though rates on HELOCs are higher now than they were with the likelihood of going higher in 2017 the rates are still much better than anything you can get on a credit card. If you’re in this situation and not sure what to do with your HELOC, pick up the phone and have a conversation with a loan officer who can provide you with some options.