What Is “The Fed” And How Does It Affect HELOC Rates?
When most people talk about “The Fed,” they usually mean the Federal Open Market Committee, or FOMC.
This committee includes 12 members of the Federal Reserve, and it controls the money supply in the US.
One tool the Fed uses to control inflation is the Federal Funds Rate, and the reserves it requires banks to set aside for depositors.
Changes to the Federal Funds Rate directly impact your HELOC payment. So what do you do if the Fed is about to raise your payment?
Federal Funds: Why They Matter
You’ve probably seen the old classic movie It's a Wonderful Life. George Bailey, played by Jimmy Stewart, loses nearly everything he owns when there’s a “run” on the bank he manages.
Photo: Wikipedia Commons. Public Domain.
The “run” happened because one depositor wanted to withdraw more money than the bank had available.
This frightened other customers, and suddenly they all lined up to empty their accounts.
Today, the Federal Reserve requires banks and other institutions to set aside money when account holders want to withdraw their money.
These funds are called “reserves,” and the Federal Reserve oversees them.
How Federal Funds Change Your Monthly HELOC Payment
Reserves ensure that there is money to pay depositors when they want it.
The Fed holds them, and institutions borrow from and lend to each other overnight as their cash requirements ebb and flow.
The Federal Funds Rate is what banks pay each other for these overnight loans.
The Fed doesn’t have the power to “change” interest rates overall.
But it does target the Federal Funds Rate, which trickles up, affecting the Prime Rate, and eventually other short-term interest rates, like your HELOC.
Federal Funds, Prime And HELOC Rates
The Federal Funds Rate represents the cost of money to banks. Think of it as the “starting point” for all other short-term interest rates.
The next step up from the Federal Funds Rate is the Prime Rate. The Prime Rate is what lenders charge their best and most credit-worthy customers.
HELOC rates are almost always tied to the Prime Rate. The rate you’re offered depends on your credit rating, the amount you borrow and the length of your loan.
HELOCs with shorter drawing and repayment periods generally have lower rates than those with longer terms.
How Much Does Your HELOC Rate Go Up?
When the Fed increases its Federal Funds Rate, the Prime Rate jumps as well.
And a Prime Rate spike causes HELOC rates to increase.
HELOC rates vary a great deal between individual lenders and consumers, but you can expect your rate, whatever it is, to increase by the approximately the amount of any increase to the Federal Funds Rate.
What Can You Do About Increasing HELOC Rates?
Just because HELOC rates in general increase doesn’t mean you can’t control what you pay as an individual. There are a few things you can do to head off a spike in your HELOC payment:
Refinance your HELOC with a fixed-rate home equity loan
Your rate and payment won’t change over the life of the loan, which should make budgeting easier. And extending your repayment period with a new loan may drop your payment.
Pay down your balance
If you’re worried about an interest rate reset, reducing what you owe should minimize the impact.
Wrap it into a first mortgage refinance
If the interest you pay for your first mortgage and your HELOC exceeds what you’d pay by combining them into a single first mortgage, refinancing makes sense. Understand, however, that most programs consider this type of refinance as a “cash-out” refi, and the costs are higher.
Check whether you can convert your variable HELOC to a fixed rate
So-called “convertible” HELOCs offer at least one opportunity to fix your interest rate according to some formula specified in the loan terms.
What Are Today’s Mortgage Rates?
If you plan to refinance your HELOC into a new first mortgage, understand that most lenders will consider this a cash-out refinance. That can increase your closing costs, depending on the lender and your loan-to-value.
However, we may be entering a rising interest rate phase. If that’s the case, replacing your variable-rate HELOC with a fixed-rate first mortgage or a fixed-rate home equity loan could be a smart move.