How HELOC Interest Rates Are Determined

Economic conditions and personal creditworthiness shape your HELOC rate

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If you need a flexible way to borrow money over time, such as for a home remodeling project, you might consider a home equity line of credit, or HELOC. These are structured so that you can borrow money during a set "draw period," which usually lasts about 10 years. After that, it converts to a "repayment period," during which you repay the remainder of the money you borrowed.

Many people prefer these loans over credit cards for one major reason: The interest rates are generally a lot lower because they're tied to the equity you have built up in your home. Although this means you could lose your home if you don't repay the loan, if you don't anticipate having repayment problems, it's a more affordable way to borrow flexible funds.

How much your HELOC will actually cost in terms of interest rates depends on several factors. If you know them, you can find ways to obtain cheaper rates on your HELOC.

Key Takeaways

  • Your HELOC interest rate is determined by two major factors: the current interest-rate environment and your individual creditworthiness.
  • The prime rate sets the baseline for what lenders might charge you, and it's affected by the federal funds rate set by the Federal Reserve.
  • Your lender also takes into account your credit score, debt levels, amount of home equity, and more when customizing your HELOC interest rate.

Factors in the Broader Interest Rate Environment

Some factors aren't within your control when it comes to what interest rate lenders offer you on a HELOC. They generally are related to broader economic conditions, which cause the baseline for what lenders charge to rise or decline. This baseline is known as the prime rate, and it's the rate lenders offer the highest-qualified customers.

Each bank sets its own prime rate, although you can get a general sense for what banks are charging by looking at averages, such as the prime rate published daily by The Wall Street Journal.

Banks set their prime rates based on the federal funds rate, which is how much it costs them to borrow short-term overnight loans to ensure they have the required amount of cash reserves on hand in case there's a run on the bank, as happened during the Great Depression.

The federal funds rate, in turn, is set by the Federal Reserve. It does so as part of a broader policy aimed at influencing big economic trends, such as keeping inflation low or spurring economic growth, when needed. That's why, in 2022, the Fed has been increasing the federal funds rate to try to spur banks to charge higher interest rates to put a brake on increasing inflation.

Borrower Riskiness Affects Interest Rates

Your lender's prime rate will set the baseline for what it could charge you as an interest rate on a HELOC. But from that baseline, the lender could adjust your rate higher, based on how risky it perceives you to be. Here are the different factors lenders consider.

Credit Score

The biggest factor influencing your interest rate for just about any loan—including a HELOC—is your credit score. The higher your credit score, the lower the interest rate you'll have to pay.

Each lender sets its own requirements for the credit scores that qualify for particular rates. But in general, if your credit score is 740 or higher (considered to be very good to excellent credit, according to credit-scoring calculation company FICO), you're more likely to qualify for the best HELOC interest rates.

If your credit score could use some work, it might be a good idea to focus on that first before seeking a HELOC. The good news is that there are several things you can do to raise your score in a short amount of time, although, typically, improving your credit score is a long-term journey.

Debt-to-Income Ratio

Having too much debt can also make you look risky in the eyes of a lender because it might mean you may have trouble affording an added HELOC payment. When it comes to this factor, there are no standardized rules about what percentage of your income should go toward debt payments (also known as your debt-to-income ratio, or DTI).

Again, each lender may set their own rules. But a good number to keep in mind is a 43% debt-to-income ratio, because that's the maximum you can generally have to get a mortgage. If your DTI ratio is above this level, you might have problems qualifying for a HELOC or other loans.

If your DTI ratio is a little high, try paying off debt using the debt snowball method or increasing your income. Both of these will lower your debt-to-income ratio to more reasonable levels, and you'll have an easier time making your payments, too.

Amount of Home Equity

Some lenders charge higher rates if you don't have enough equity built up in your home yet. This also relates to your debt level because the more mortgage debt you have (in other words, less home equity), the more of a risk you run of defaulting on your HELOC.

If you don't have at least 15% to 20% equity in your home, it might be time to focus on paying down your mortgage first or pursuing another option.

How To Get the Best HELOC Interest Rates

HELOCs are one of the more confusing, but often worthwhile, types of ways you can borrow money. As such, it's especially important that you shop around to make sure you're getting the best rates and that you fully understand how the HELOC works. You can do this by keeping the following actions in mind:

  • Check your credit reports: It's not uncommon for credit reports to have errors that can affect interest rates. So before you start shopping, check your credit reports to make sure they're accurate and that you're not unfairly penalized.
  • Keep track of your estimates: You'll need to compare a lot of details to find the best HELOC for you. A HELOC pamphlet from the Consumer Financial Protection Bureau (CFPB) has a great fill-in worksheet you can use to compare the quotes received.
  • Contact as many lenders as possible: By reaching out to more lenders to ask for a quote, you increase your odds of finding the best option for you. Check with banks, credit unions, and online lenders to make sure you're covering all bases.
  • Get your rate shopping done fast: Each time a lender does a hard credit check, it could ding your credit score slightly. But if you get all your rate-shopping done in a two-week period, they will be bundled and recorded as a single inquiry, which will help preserve your credit score.

Alternatives to HELOCs

Getting a HELOC requires meeting certain criteria, such as having sufficient equity in your home. If you don't meet the requirements of these lines of credit, or if you'd rather look into other options, consider these HELOC alternatives:

Home Equity Loan

If you need to borrow a lump sum, rather than having it drip out over time with a HELOC, then consider a home equity loan. These are also tied to your home's equity, which means you can get cheaper rates than with an unsecured product like a personal loan.

Credit Card

Credit cards are the most common alternative to HELOCs. Because they're not tied to your home, you won't run the risk of losing your residence if you default. Credit cards also can offer rewards, such as free flights or cash back.

The downside of using credit cards for financing is that they're much more expensive, with an interest rate three times greater than what you can expect to pay for a HELOC.

Unsecured Line of Credit

An unsecured line of credit is basically the same as a credit card, but generally without a card issued. You might get a book of checks you can use to draw against your credit line, for example, or an ATM card. Or it could serve as a backup source of funds in case you overdraw your account. Unsecured lines of credit aren't quite as common as HELOCs and some other options, but you can still find them at some banks and credit unions.

Frequently Asked Questions (FAQs)

When do HELOC interest rates change?

It depends on the contract you have with your lender, but interest rates on HELOCs can change as often as every month.

How much equity do you need to get a HELOC?

Lender requirements differ, but you'll generally need at least 20% to 25% equity in your home before you're eligible to apply for a HELOC.

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