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Why You Should Consider a Home Equity Loan as Interest Rates Rise

Unemployment is low, job satisfaction is high, the gross domestic product is up, corporate profits are rising and investment as a percentage of the economy is right about where it was during the mid-2000s boom. Simply put, the economy is growing. And while that’s good news in many ways, there’s one way in which homeowners might be feeling a pinch: rising interest rates.

In September 2018, the average interest rate on a home equity loan was 5.485%, according to the most recent LendingTree data. That’s up nearly a full percentage point since the beginning of the year.

If you’ve been thinking about a home equity loan to pay off higher rate debts or fund a home remodeling project, did you miss the boat on low interest rates? To some extent, yes. We probably won’t see rates below 4% any time soon. But there may still be good reason to consider a home equity loan as interest rates rise.

What are the different ways to tap home equity?

There are a few ways to tap your home equity, each with their own pros and cons.

Home equity loans

A home equity loan (HEL) is also known as a second mortgage. You keep your existing mortgage but borrow against your home’s equity in a one-time event.

The benefit is that interest rates on a home equity loan are typically fixed, so as interest rates rise, your payments are not affected. On the flip side, a home equity loan usually comes with higher interest rates than what you would receive from a HELOC or cash-out refinance. You’re trading a higher interest rate for stability in the amount you’ll pay over time.

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HELOC

A home equity line of credit (HELOC) is similar to a credit card in that it is a revolving line of credit that you can borrow against over and over again during the loan’s borrowing period.

The upside of a HELOC is it provides flexibility in the amount you borrow and when. Like a credit card, you only use what you need, when you need it and you don’t have to pay interest on the line of credit unless you actually withdraw the money. Typically, their interest rates are initially lower than those available through a HEL. However, interest rates on a HELOC are generally variable. In a period of rising interest rates, as your interest rate rises, so will your monthly payments.

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Cash-out refinance

A cash-out refinance is not in addition to your existing mortgage. Instead, you refinance your current mortgage into a new mortgage with a higher balance than your current loan. Proceeds from the new loan are first used to pay off your existing mortgage. Then you receive the difference between the two loans in cash.

Interest rates on a cash-out refinance may be fixed or adjustable, and they’re typically lower than the rates that would be available on either a HEL or HELOC. However, in a period of rising interest rates, you may not be able to get an interest rate lower than the one available on your current mortgage.

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When is it a good idea to borrow from your home’s equity?

When is it a good idea to tap your home’s equity?

It’s a good idea when the cost of borrowing is lower than other alternatives.

“A home equity loan might be beneficial as a tool to consolidate higher interest rate debt, such as credit cards or personal loans,” said Levi Sanchez, CFP and co-founder of Millennial Wealth, a fee-only financial planning firm in Seattle. “In a high interest rate environment, it’s important to know that variable interest rates will rise with overall rates and cost you more.”

Example: Say Amir has $10,000 in credit card debt with a 16.5% interest rate and a $15,000 balance on a variable rate student loan with a 6% interest rate. If interest rates continue to rise, Amir’s monthly payments will increase and his cost of borrowing will go up.

If Amir could tap his home equity and consolidate those debts into a home equity loan with a lower fixed interest rate, he may be able to reduce his overall interest rate and minimum monthly payment. However, he needs to consider how long it will take him to pay off that debt. Amir may be able to lower his interest rate and monthly payment to save money in the short term, but if he’s paying off that debt over an extended period of time, he will likely pay more in interest than he would have otherwise.

Let’s run the numbers to see that in action. Say Amir is paying $300 per month toward his credit card and $200 per month toward his student loan. Let’s see how his monthly payment, the time frame to pay off his debt and total interest paid would change if Amir refinanced those debts into a home equity loan with a 15-year term and a fixed interest rate of 5.75%.

Credit Card vs Student Loan vs Home Equity Loan
Credit Card Student Loan Home Equity loan
Beginning Balance $10,000 $15,000 $25,000
Interest Rate 16.5% 6% 5.75%
Monthly Payment $300 $200 $208
# Months to Payoff 45 95 180
Total Interest Paid $3,468.77 $3,847.20 $12,326

As you can see from the table, Amir could drastically lower his interest rate and monthly payment by refinancing, but wind up paying nearly twice as much in interest because he stretched out his repayment term to 15 years with the home equity loan.

However, what would happen if Amir could refinance and pay more than the minimum payment? What if Amir decided to pay $1,000 per month toward the home equity loan?

Home Equity Loan with a Higher Payment
Home Equity Loan
Beginning Balance $25,000
Interest Rate 5.75%
Monthly Payment $1,000
# Months to Payoff 27
Total Interest Paid $1,693

In that case, Amir could pay off his debt in a little over two years and reduce the total interest paid by more than $10,000.

What will happen to home equity rates?

The calculation above assumes that the interest rates on Amir’s credit card and student loan will remain constant over the payoff period. But that’s unlikely in the current economy.

The Federal Reserve raised rates three times so far in 2018, most recently in the third quarter when the benchmark federal funds rate was lifted to a range between 2% and 2.25%. It’s expected to raise rates by one percentage point through 2019 and at least one more quarter-point increase in 2020.

Alternatives to home equity loans

Of course, one of the main drawbacks to borrowing against your home’s equity is that your home is used as collateral. If you run into financial difficulties and default on your loan, your lender can foreclose on your home.

For that reason, it’s a good idea to compare home equity borrowing options against other loans that won’t put your home at risk. These include:

  • Credit cards
  • Personal loans
  • 401(k) loans
  • Auto loans
  • Business loans
  • Student loans

The bottom line

A fixed-rate home equity loan can provide a locked-in interest rate and fixed payments over the life of the loan. You won’t have to worry about rate fluctuations as you would with variable rate debt such as credit cards, home equity lines of credit or adjustable rate cash-out refinance loans.

Interest rates overall are still at relatively low levels, but they are climbing. For this reason, if you’ve been considering taking out a home equity loan, you may want to act sooner rather than later to avoid further rate hikes.

 

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