How Home Equity Loan Interest Rates Are Determined

Learn what factors affect your home equity loan rate

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Home equity loans allow you to borrow against your home equity to use for any expense, such as for home improvements or emergencies. Since these loans are secured by your home, you can often get much lower rates than you can with unsecured loans such as personal loans or credit cards.

Interest rates are affected by both the economy and your personal financial situation. Broader economic conditions determine the interest rate environment. Lenders then look at your personal financial health, measured by metrics such as your credit score, to determine the rate you receive. Learn more about how these two factors affect your home equity loan rate.

Key Takeaways

  • Economic conditions impact the prime rate, which is the baseline for how lenders determine home equity loan rates.
  • Your lender will customize your interest rate based on your personal finances.
  • Compare rates from different lenders to get the best one and save money.

Factors in the Broader Interest-Rate Environment

The interest rate you are offered on a home equity loan is based in part on broader economic factors. Lenders have a prime rate, which is the interest rate determined by banks and often based on the Federal Reserve’s federal funds rate.

The Fed uses monetary policy of setting the federal funds rate to manage the economy. For example, if inflation is high, the Fed may raise its benchmark interest rate. The federal funds rate then affects the prime rate that many banks use as a baseline for where they set individual interest rates.

Borrower Riskiness Impacts Interest Rates

The prime rate essentially is the baseline for what a lender charges for interest rates on a home equity loan. From there, they adjust the rate they offer you based on your riskiness as a borrower.

You can control some of these personal financial factors that affect your rate, such as your credit score, your debt-to-income ratio, and the length of the loan.

Credit Score

One of the biggest factors in adjusting your personal interest rate on a home equity loan is your credit score. This is a measure of how likely you are to repay your debts. If you have a history of managing your debt well, you'll likely have a high credit score, and vice versa.

Credit scores are based on factors such as your missed-payment history, the length of your credit history, the amount of revolving debt you are using, your credit mix, and the amount of new credit you have.

Each lender has systems for adjusting rates based on your credit score. In general, if you have a FICO score of 740 or above, which is considered a “very good” or “excellent” score, you'll usually qualify for the lowest interest rates.

Debt-to-Income Ratio

Lenders also consider your debt relative to your income when they assess your risk. You calculate your debt-to-income ratio by dividing your monthly debt payments by your monthly income.

For mortgages, including second mortgages, leaders typically require a 43% debt-to-income ratio, but requirements vary by lender. If you have a high debt-to-income ratio, consider paying down some of your debts to reduce your total monthly debt obligation.

Term Length

The longer you have the loan out, the greater the risk that you won't be able to repay your loan. During a longer time period, for example, the risk is higher that you might lose your job or face a financial setback. So lenders generally charge a higher interest rate on longer-term home equity loans.

Home equity loans generally range from five years to 30 years in length. So if your goal is to minimize the total interest you pay, choose the shortest-term loan with monthly payments that you can afford.

How To Find the Best Interest Rates on Home Equity Loans

Each lender is different. Some may specialize in helping certain types of people, or they could aim to be more competitive in general by offering lower rates than other lenders. This is why it's important to shop around to get the best rates possible on a home equity loan.

  • Check with several lenders: Comparing home rates increases your odds of finding the lowest rate.
  • Include credit unions and online lenders: Credit unions often offer lower rates than banks. Loans from online lenders can be even more affordable.
  • Focus on the APR: The APR includes any fees. Comparing APRs from lenders instead of the interest rate alone will help you determine the more affordable loan.
  • Keep good notes: Create a spreadsheet or list of each lender and include the APR, date you received the quote, fees, and whether the loan is fixed rate or variable rate.
  • Compare all rates within two weeks: You can limit the impact to your credit score by applying for different loans within two weeks. That way, all the credit checks are recorded as a single credit inquiry.

Alternatives To Home Equity Loans

A home equity loan isn't an option for many people. If you've just taken out your mortgage, for example, you might not even have enough equity in your home yet to be eligible for a home equity loan. In any case, there are other options available to you if you need to borrow money.

Personal Loans

A personal loan is similar to a home equity loan, except it is an unsecured loan, so it isn’t backed by collateral. Therefore, the risk to the lender is higher, and so are the interest rates.

Home Equity Lines of Credit

A home equity line of credit (HELOC) is similar to a home equity loan in that it's backed by your home equity. So, rates are more affordable than other funding sources, such as unsecured loans.

However, instead of getting a lump sum, you borrow money as needed, much like with a credit card. A HELOC provides a flexible source of funds and can be a better solution if you're not sure how much money you will need.

Cash-Out Refinance

A cash-out refinance allows you to refinance your mortgage for a larger amount than you currently owe. You'd then get the difference back as cash that you can use for any purpose. Keep in mind that a cash-out refinance will likely increase the amount of time you'll be paying back your mortgage and/or your monthly payment.

Need-Based Grants and Loans

Many local programs offer assistance through need-based grants and affordable loans for people who qualify. You can find many of these options through your state's housing finance commission, or visit 211.org to connect with a counselor who can review options available in your community.

Frequently Asked Questions (FAQs)

Which has higher interest rates, home equity loans or home equity lines of credit?

Home equity loans usually have a fixed rate that doesn't change. Home equity lines of credit (HELOCS) usually have variable rates, so they can change according to market conditions. Rates vary by lender.

How does inflation affect interest rates?

Inflation can cause interest rates to rise for two main reasons. First, lenders will boost the interest rates they charge in order to keep pace with rising costs. Second, the Federal Reserve often adjusts the federal funds rate to curb inflation, which in turn causes the rates banks charge you to rise.

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