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Home equity loans and lines of credit each allow homeowners to tap their home equity and turn it into cash, and both let you use those funds for whatever you wish. They have key differences, though, including their interest rates — both in how their rates work and how they’re determined. It’s crucial to understand these differences when choosing between the two mortgage types.
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Use these strategies to build wealth through your home equity.
How HELOC rates are determined
Most HELOCs are variable-rate products, meaning their interest rates are impacted by an outside interest rate. When that rate rises or falls, the rate on your HELOC generally follows suit.
HELOCs are typically tied to the prime rate, which is the baseline rate that banks currently charge their most creditworthy customers. The Wall Street Journal publishes an aggregate prime rate set by a minimum of 70% of the 10 largest American banks.
In addition to this rate, a HELOC lender will assess the risk the borrower presents and add a margin to protect itself. Riskier borrowers will have larger margins, while those considered less risky will receive smaller ones.
Factors such as your credit score, debt-to-income ratio (DTI), and loan-to-value ratio (LTV) will all be considered in this assessment.
Here’s an example: Say a bank’s prime rate is 5%. The bank looks at the above factors and determines you have good credit, low DTI and LTV ratios, and are at low risk for non-payment. As a result, they add just a 0.5% margin, giving you a total starting rate of 5.5% on your HELOC. (Had your credit been worse, you might have faced a much higher margin, pushing your rate up to 7% or 8%, for example.)
How home equity loan rates are determined
A home equity loan (and its interest rate) works like a HELOC in some ways and a traditional primary mortgage in other ways.
As with a HELOC, the prime rate usually impacts your home equity loan rates, and lenders incorporate a margin into your rate. Both HELOC and home equity loan rates are loosely influenced by the Federal Reserve’s federal funds rate as well as broader economic conditions.
However, like many first mortgages, home equity loans are typically fixed-rate products, meaning you’ll have the same interest rate for the entire term. Fixed-rate HELOCs exist, but they’re much less common.
Your home value, credit history, loan details, and financial profile, including your income, debts, and credit score, also play a significant role in determining whether home equity loan lenders approve your application.
Although home equity loan rates are more straightforward and work similarly to a typical fixed-rate mortgage loan, you can expect HEL rates to be higher than primary mortgage rates.
For example, at the time of publication, the Rocket Mortgage home equity loan displays a 9.375% rate on a 10-year term. Meanwhile, the website advertises a 6.375% rate on a 30-year conventional mortgage.
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How to get the best HELOC and home equity rates
While there’s not much you can do about the prime rate or general market conditions, there are plenty of rate-influencing factors that are within your control. Taking the time to explore the following strategies before applying for your home equity loan or HELOC can help you secure the lowest rate possible.
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Boost your credit: The best interest rates are typically reserved for borrowers with high credit scores. Aim to get yours above 700 if it’s not already there. Reducing your debts and paying your bills on time can both help improve your credit score.
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Increase your home’s value: A higher home value means you have more home equity as well as more cushion against market fluctuations and downturns. Sometimes, your home's value will increase naturally as demand for buying rises in your area. You can also increase it yourself by making strategic renovations and updates.
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Borrow less: The less money you borrow with a HEL or HELOC, the lower your monthly payments will be — and your lender has less to lose if you default on your loan, which could make your application more appealing. Try to minimize your loan balance and only borrow what you consider necessary.
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Shop around for your lender: Rates and fees can vary quite a bit between lenders and banks, so get quotes from at least a few different companies before choosing a mortgage lender. Also, be sure you’re requesting quotes for the exact same loan product and term with each one. This will give you the most accurate comparison across lenders.
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Increase your income: More income means you have more money to put toward your second monthly mortgage payment, not to mention more cash to handle any financial hiccups that might come your way. It also decreases your DTI ratio, a key factor in determining your rate and whether you qualify for a loan in the first place.
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Reduce your debts: Paying down debt also lowers your DTI ratio and makes it easier to get a good interest rate. But if you pay off a credit card for the sake of improving your financial profile, you probably don’t want to close the account. The length of your credit history counts for 15% of your FICO credit score.
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Take out a shorter loan term: With home equity loans, shorter terms tend to have lower interest rates than longer ones (e.g., a 10-year HEL will usually have a lower rate than a 20-year one). Just keep in mind that the monthly payment will be higher because you’re paying off your balance in a shorter chunk of time.
In general, anything you can do to reduce your risk in the eyes of a lender, the better. That means having more money, more equity, a better payment history, or less debt — all of which make it easier to make your payments and repay your loan or line of credit in the long run.
HELOC and home equity loan rates FAQs
Do home equity loans or HELOCs have better rates?
Interest rates on home equity loans and HELOCs are fairly comparable, though depending on the prime rate and lender, that isn’t always the case. Be sure to shop around and compare quotes if you’re unsure which product is most affordable for your needs.
Is a HELOC a trap?
A HELOC is a legitimate financial product that can be valuable to homeowners if used wisely. It does come with risks, though, as it uses your home as collateral. This means if you fail to make payments, your lender could foreclose on your house. However, this is also the case with first mortgages and home equity loans, not just HELOCs.
What is the cheapest way to borrow from your home equity?
Some common ways to access your home equity include home equity loans, HELOCs, reverse mortgages, and cash-out refinances. The cheapest option depends on several factors, including your credit, your home’s value, your age, and your current mortgage details, among others. Consult with a mortgage professional to run the numbers for your specific situation.
Laura Grace Tarpley edited this article.
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