Why HELOCs are becoming a popular way to unlock equity

This story is part of Recession Assistance BureauCNET’s coverage of how to make smart money moves in an uncertain economy.

As home values ​​surged during the pandemic, homeowners have record equity in their homes: Americans now have more than $18 trillion in total equity. Given the economic turmoil, many are looking for efficient ways to cash in on their home’s equity (the current market value minus what is still owed on the 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 withdraw money over a period of years and make interest-only payments on what you’ve borrowed . Some use a HELOC for home improvement projects, while others may 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 probably won’t make sense to complete a payoff refinance — where you replace your original mortgage with a new, more expensive mortgage with a lower interest rate and get the difference as a lump sum — now that mortgage rates are more than 2% higher than they were at the start of this year. For example, if you recently locked in a 3% interest rate on your mortgage, a payoff refi will put you at a disadvantage because 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, you’re just 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 fight inflationand many experts expect HELOC rates to continue to rise. “Every time the Federal Reserve raises rates, it filters down to HELOC borrowers, often within 60 to 90 days,” said Greg McBride, chief financial analyst at Bankrate, a CNET affiliate.

Nevertheless, a HELOC can remain a more strategic financial move compared to a cash-out refinance, mainly because the loan principal is smaller. Read on to learn how the Federal Reserve affects 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 returned to favor this year as borrowers who locked in historically low mortgage rates in 2020 and 2021 have been reluctant to give up their lower rates by refinancing as refi rates currently hovering around 5.5%.

Unlike a HELOC, with a payoff refi, you take on an entirely new mortgage that you pay off over the life of the loan. With a HELOC, you only borrow a set amount of money that you can repeatedly withdraw over a set period of time, usually 10 years, and that you must pay back over a set period of time, usually 20 years.

“Amid record high home prices, many homeowners have seen their property values ​​increase, making HELOCs a potential option for raising capital,” said Robert Heck, vice president of mortgages at Morty, an online mortgage marketplace.

Where Are HELOC Rates Going?

It’s a safe bet 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 raising interest rates means that HELOC borrowers are seeing interest rates go up, and the interest you pay at the end of the year could be 3 or 3.5 percentage points higher than what you started the year,” McBride said.

The Federal Reserve’s latest rate hike of 0.75% in July was one of the largest rate hikes since 1994. “The Fed is not done raising rates, and the only question is how much more they need to raise rates to quell inflation,” McBride said.

It’s important to keep in mind that HELOC rates are variable and rise and fall with interest rate trends in general, as well as the prime rate, which is the main interest rate that banks use to set loan rates. HELOCs are directly exposed to Fed rate hikes because their variable interest 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 rate product like a HELOC.

“One thing borrowers with low promotional interest rates need to know is that rising interest rates may not affect you now while you have the low promotional interest rate, but they will certainly affect the interest rate you pay when that promotional period has expired,” McBride said. “Some borrowers see interest rates jump from 5% to 9.5% or 10% when the 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 collateral that secures your loan, if for any reason you default or are unable to repay your loan, the bank or lender may foreclosure on your house to pay off. That’s why it’s critical to make sure you can afford the monthly payments if the variable interest rate on your HELOC increases.

But there are ways to reduce 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 protect 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 job and your assets and reserves can provide some security. In this time 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 and conditions associated with the loan and assess their financial goals to ensure a HELOC is the right way to access credit,” Heck said. .