What’s the Best Way to Use Home Equity When Rates Are High?

How Rising Rates Affect Home Equity

When the Fed increases the federal funds rate, it becomes more costly for banks to borrow money. These costs are then passed along to borrowers in the form of interest rate hikes on debt products such as loans and credit cards. If you have a fixed-rate mortgage, you're insulated from these rate hikes as far as your existing mortgage loan is concerned, but rates are important to consider when tapping home equity is on the table.

Rising interest rates have changed the approach many homeowners have taken to tapping their home equity since options that were previously a prudent financial move make less sense in a high-interest environment. For example, cash-out refinancing, which was all the rage when interest rates were near zero, is now nearly flatlined. Homeowners who snagged low-interest mortgages would end up paying much more interest (and a higher monthly payment) if they were to refinance their loan into a new mortgage with a much higher rate. While down from October, the average interest rate for 30-year, fixed-rate mortgages stayed near record highs at 6.49% as of December 1, 2022, according to Freddie Mac.

Still, some homeowners may want to access a portion of their home's equity to pay off high-interest credit cards or fund a home renovation project. The interest rate for home equity loans is typically higher than a rate-and-term-refinance, but could be a good option if it means avoiding higher-interest alternatives.

Pros and Cons of a Home Equity Loan

Pros

Home equity loans can offer a path to access your home equity to help you achieve an important financial goal or milestone. Here are some other benefits home equity loans offer:

• Fixed interest rate: Home equity loans are installment loans with a fixed interest rate. As a result, your payment remains the same for the life of your loan, even as interest rates fluctuate.
• Consolidate high-interest debt: You may accelerate your debt repayment schedule and save money in interest charges by securing a home equity loan with a lower interest rate. Doing so may not be a good idea in some cases. However, if your home value declines, you could end up underwater on your loans.
• Countless uses: Home equity loans are often used to fund a kitchen or bath renovation or other home improvement projects. Ultimately, you can use a home equity loan for virtually any purpose.
• Lower interest rates: Because your home serves as collateral on the loan, home equity loans typically feature lower interest rates than other types of credit.

Cons

On the other hand, home equity loans come with downsides you must consider before applying for a loan.

• Higher risk: Since your home is the collateral on the loan, you could lose your home if you default on the payments.
• Credit score requirements: Generally speaking, you may need a FICO^® Score^☉ of at least 660 to qualify for a home equity loan, although a score over 700 will improve your odds of qualifying with favorable terms. Lenders also take your income, debt-to-income ratio and other factors into consideration when determining your creditworthiness for a loan.
• Equity requirements: Many lenders require you to keep at least 15% equity in your home. Consequently, you may be able to borrow up to 85% of your home's equity.
• Second mortgage: Your finances could be more challenging to manage with an extra mortgage payment on top of your primary mortgage.
• Closing costs: Closing costs, including origination, appraisal and other fees, may range from 2% to 5% of the loan amount. This means your closing costs could add $200 to $500 for every $10,000 borrowed.

Pros and Cons of a Home Equity Line of Credit

Pros

A HELOC's variable APR can fall when the Fed lowers the federal funds rate. As a result, HELOCs often come with lower interest rates than home equity loans in a low-interest environment. With a HELOC, even if your rate is high now, it could become lower in the future (and likewise).

• Low minimum payments during draw period: You can typically make interest-only payments during a HELOC's draw period, which usually lasts 10 years.
• High credit limits: With your home as loan collateral, you may be able to borrow up to 85% of your home equity.
• Lower interest rates: Like home equity loans, HELOC interest rates are usually lower than those for credit cards and personal loans. Some HELOCs even allow you to convert some or all of your balance to a fixed-rate loan.
• Pay interest on only what you need: With a line of credit, you pay interest only on the amount you borrow, not on the amount of your credit line.

Cons

HELOCs can deliver lower rates when interest rates are falling, but the opposite is also true. As rates rise, so do the interest rates on HELOCs. Keep an eye on interest rate trends when deciding between a HELOC and a home equity loan.

Other downsides to HELOCs include:

• Potential for foreclosure: Like home equity loans, you could lose your home if you fail to make your payments and default on the loan.
• Payment instability: Your payment could jump some months, which could be hard to manage if you're not prepared. Before taking out a HELOC, make sure you understand the terms, including the maximum interest rate.
• Potential for unaffordable repayment-period payments: After several years of spending while simultaneously making interest-only payments, you'll begin the HELOC's second phase—the repayment period. Payments during this time are significantly higher since you must pay the principal and interest on your HELOC.
• No access to funds during repayment period: With a typical 30-year HELOC, you'll have a 10-year draw period to withdraw funds as needed. Once the draw period closes, a 20-year repayment period follows, during which you can no longer access your HELOC while you pay back the borrowed money.

Pros and Cons of a Cash-Out Refinance

Pros

In a low-interest environment, a cash-out refi can give you an infusion of cash while lowering your interest rate. But when rates rise, the interest rate on a new rate-and-term loan may be higher than that of your existing loan, making it a less desirable option to tap into your equity.

The following are benefits you might find with a cash-out refinance:

• Long repayment period: If you have a 15-year mortgage, you could refinance into a 30-year home loan to stretch out your payments, but doing so may result in higher interest charges over the life of the loan.
• Possible lower rate: When interest rates are low, a cash-out refinance could leave you with a new loan at a lower interest rate. Simultaneously, refinancing could give you the money you need to renovate your home, pay off high-interest credit cards or use them for almost any purpose.

Cons

On the other hand, there are some potentially negative factors to consider before doing a cash-out refinance.

• Puts your home on the line: A cash-out refinance raises your balance and your monthly mortgage payment. If you can't make the higher payments, you risk foreclosure.
• Closing costs: Refinancing your mortgage loan can cost you 2% to 5% of your loan amount in closing costs, which you can elect to pay upfront or roll into your new loan.
• Potential to pay private mortgage insurance: If your cash-out refi leaves you with a balance that exceeds 80% of your home's value, you could be on the hook to pay private mortgage insurance.

What's the Best Way to Tap Into Home Equity During a Rate Rise?

Home equity loans, HELOCs and cash-out refinance loans are all more expensive when rates rise. Remember that with your variable-rate options, your payment will rise when the Fed raises rates. The best option for you to tap your home equity depends on your financing needs, comfort with risk and other factors.

It's essential to look for ways to mitigate your risk when you want to take out a chunk of equity to pay for a major project or purchase another home. Before applying for a new loan, speak with your lender about your budget and goals so you can work together to find the right option. It's also a wise practice to use a mortgage calculator to get a clearer view of how a mortgage loan could impact your budget.

Shore Up Your Credit Before You Take Out Home Equity

No matter what method you use to access your home equity, you'll want to get the best interest rate possible. To do so, you'll need your credit to be in tip-top shape. Before applying, check your credit by accessing your credit report and score for free with Experian.

You may take steps to strengthen your credit score by making consistent on-time payments on your credit accounts, keeping your balances low and following other credit-improving tips.