Navigating Home Equity Loans in a High Interest Rate Environment

Home equity loans allow you to unlock some of the cash tied up in the value of your home without having to move out. They’re relatively more affordable than other lending options, making them quite popular among homeowners looking to access cash for various reasons.

But are home equity loans still a viable option in a high-interest-rate environment? In this article, we go through the upsides and downsides and suggest when it might or might not be a good option for you.

What Is a Home Equity Loan?

A home equity loan, also sometimes called a second mortgage, is a type of loan that allows you to borrow funds against the equity you’ve built up in your property. Equity refers to the difference between your home's current market value and the remaining balance on your mortgage.

With a home equity loan, you receive a lump sum of cash that you repay over a specified term. The interest rate on this loan is fixed, which provides predictability in repayment amounts.

Home equity loans use your home as collateral. This lowers the risk for lenders, and as a result, these loans have lower rates compared to unsecured options, like personal loans. What’s more, home equity loans offer longer repayment terms (typically 5- 30 years), which translates to lower monthly repayments.

Another closely related product to a home equity loan is a home equity line of credit (HELOC). With HELOCs, you don't receive all the cash upfront. Instead, the lender grants you access to a revolving line of credit, similar to a credit card. You can draw on this credit line as needed during a designated draw period (typically 5-10 years).

The Current High-Interest Rate Environment

Lenders typically tie their rates on home equity loans to the prime rate—the rate lenders charge their most creditworthy customers. The prime rate, in turn, is pegged to the federal funds rate—the rate that banks charge each other for overnight lending of their cash reserves.

When the federal funds rate goes up, the prime rate likewise goes up, as does the rate lenders charge you for a product like a new home equity loan.

As of July 23, 2024, the federal funds rate was 5.25-5.5%, the highest level in 23 years. That means we’re currently in a high-interest rate environment, which is due to several factors, the biggest one being inflation.

Inflation, as you probably know, has been quite high recently. To combat it, the Federal Reserve, which is in charge of US monetary policy, has increased the federal funds rate. This is a typical response to cool down the economy by discouraging borrowing and spending.

Impact of rising home prices

Home prices have surged 54% since 2019. In 2023 alone, prices were up 5.8%. While rising prices can make purchasing a home difficult for aspiring buyers, it’s usually good news for existing homeowners considering a home equity loan.

Here’s why.

As your home’s value rises, the difference between your mortgage balance and the market value (your equity) grows as well. This can be beneficial even in a high-interest-rate environment since it gives you access to a potentially larger pool of funds through a home equity loan.

Rising home prices also reduce your lower loan-to-value (LTV) ratio. The LTV is the ratio of your remaining mortgage balance to your home’s current value. Usually, the lower your LTV, the better the terms you can get on your home equity loan. These benefits of rising home prices can make a home equity loan worth it even in a high interest rate environment.

Pros and Cons of Taking Out a Home Equity Loan in High Interest Rate Periods

Taking out a home equity loan during periods of high interest rates has pros and cons. Here’s a breakdown.

Pros

• Access to a large sum of money: A home equity loan allows you to borrow a significant amount compared to other loan options like personal loans. This can be helpful for financing major expenses.

• Potentially lower rates than other options: Even in a high-interest rate environment, a home equity loan may still offer a lower interest rate than other unsecured loan options, such as personal loans.
• Potential tax benefits: The interest you pay on a home equity loan may be tax-deductible if you use the funds for qualified home improvements. This can significantly reduce your overall borrowing costs.
• Paying off high-interest debt: Taking out a home equity loan and using it to pay off credit card debt or other high-interest loans can potentially save you money in the long run. Even with a higher rate on the loan, it might still be lower than what you’re currently paying.

Cons

• Higher borrowing costs: While home equity loans generally cost less than other types of loans, taking them up in a high-interest rate environment still means you'll pay more for the money you borrow.
• Risk of foreclosure: Your home acts as collateral for an equity loan. Defaulting on the loan could result in foreclosure. A high-interest rate environment where monthly repayments are likely to be higher heightens this risk significantly.
• Strained finances: Adding another debt obligation can strain your finances, especially if your monthly payments are higher due to increased interest rates. This could impact your financial stability and make it harder to manage other expenses.

When Should You Consider a Home Equity Loan?

Here are some scenarios in which taking out a home equity loan might make sense, even in a high-interest rate environment.

• To finance home improvements: If you're planning significant renovations that can add value to your home, a home equity loan can be a good option. The increased value plus tax benefits can potentially offset the borrowing costs.
• To consolidate debt with it: If you're struggling with high-interest debt on credit cards or other loans, a home equity loan can help consolidate it into a single loan with a potentially lower interest rate. This can simplify your repayment process and save you money in the long run.
• Investing in your future: Using a home equity loan to invest in education or career development can be a strategic move, particularly if it leads to a better job or higher future earnings that will help you comfortably repay the loan.

That said, there are situations where a home equity loan might not be the solution, especially in a high-interest-rate environment. Here are some examples:

• You have an unstable income: If your income is unpredictable or unreliable, taking on additional debt can be risky. A home equity loan requires consistent income to comfortably manage the monthly payments throughout the loan term.
• You want to fund non-essential expenses: Only use the home equity for strategic purposes that will improve your financial situation in the long run. Avoid using it for frivolous spending or impulsive purchases.
• You are carrying other big debts: If you're already burdened with a considerable amount of debt, adding a home equity loan can further strain your finances. Only consider this option if you plan to use the funds to consolidate existing debt into a potentially lower interest rate loan. Otherwise, focus on addressing those other debts first.

Strategies to Manage High Interest Rates

High interest rates can undoubtedly make borrowing more expensive. However, there are steps you can take to secure the best possible rate for your home equity loan:

• Maintain a good credit score: Your credit score is a major factor in the rate you get from a home equity loan. Keep your credit score in good shape by paying your bills on time, managing your overall credit utilization (ideally below 30%), and checking your credit report regularly for errors and having them rectified.
• Consider the loan term: A shorter loan term typically comes with a lower interest rate. However, it also translates to higher monthly payments. Ensure your budget can comfortably accommodate these higher repayments before opting for a shorter term.
• Shop around and compare rates: Don't settle for the first home equity offer you come across. Compare rates and terms from multiple lenders to find the most favorable option for your needs.
• Negotiate the rate: Don't be afraid to negotiate the interest rate with the lender. Having a good credit score, strong financial standing, and even competing offers from other lenders can give you leverage during these negotiations.

Alternatives to Home Equity Loans

If you determine that a home equity loan is not the best solution for you, there are other alternative financing options to consider.

• Cash-out refinance: This involves refinancing your existing mortgage for a higher amount and taking the difference in cash. However, refinancing typically comes with closing costs, and you may end up extending the term of your mortgage.
• Personal loan: Personal loans are unsecured loans offered by banks, credit unions, and online lenders. While they usually come with higher interest rates than home equity loans, the application process can be faster and easier.

Conclusion

Home equity loans are useful and relatively affordable ways for homeowners to access large sums of cash for various purposes. However, during periods of high interest rates, it's crucial to approach them with caution.

More specifically, carefully evaluate your financial situation—including your ability to afford the higher monthly repayments—before you apply for the loan. In addition, only use this funding option for strategic purposes like consolidating other high-interest debts, investing in your future, or making value-adding home improvements.

Remember that maintaining a good credit score, opting for a shorter loan term, and comparing rates and terms from multiple lenders using a platform like mortgagelenderscompared.com can also help you minimize your borrowing costs.