What Happens to Your HELOC When Interest Rates Rise?

When you have a need to borrow money, you have choices. You could take out a personal loan and use the proceeds as you see fit. Or, you could tap the equity you have in your home.

In this regard, you have a few choices. With a home equity loan, you're borrowing a specific amount of money at a specific interest rate. To put it another way, you're signing up for fixed payments until your loan is paid off.

You could also sign up for a home equity line of credit, or HELOC. With a HELOC, you're not locking in a specific loan amount. Rather, you get access to a line of credit you can tap as needed during a predetermined time frame, whether it's five years, 10 years, or longer.

The upside of getting a HELOC is that you get flexibility. Say you're borrowing to complete a home renovation and you don't know exactly what your final costs will be. If you take out a $20,000 home equity loan but wind up needing $24,000 to finish your work, you'll be short $4,000. If you sign up for a $30,000 HELOC, you could simply borrow the $24,000 you need, leave the remaining $6,000 untapped, and only accrue interest on the sum you've actually withdrawn.

But while HELOCs may be convenient, one drawback associated with them is that their interest rates tend to be variable. And that means that when the Federal Reserve raises interest rates, it has the potential to make an existing HELOC more expensive to pay off.

Brace for higher costs if you have an existing HELOC

You may have seen that the Federal Reserve has been raising interest rates in an effort to slow the pace of inflation. The Federal Reserve doesn't set HELOC rates, or any consumer borrowing rates for that matter. Rather, the Fed dictates what the federal funds rate looks like, which is the rate banks charge each for short-term borrowing.

But when the Fed raises that benchmark interest rate, it tends to drive the cost of consumer borrowing up across the board. So if you're looking to sign a new home equity loan, for example, you might end up with a higher interest rate today than you would've locked in a year ago, assuming your credit score hasn't changed.

How does this tie into HELOCs? Let's say you've been making payments on a HELOC and are barely able to fit them into your budget. In light of the Fed's recent rate hikes, you could soon see your HELOC payments rise even more. That could put you in a tough spot, because falling behind on a HELOC could mean suffering major credit score damage. It could also, in time, put you at risk of losing your home, since your HELOC is secured by your home.

Be careful when signing a HELOC

It's easy to see why a HELOC might seem like an optimal borrowing choice. But remember, any time you sign up for non-fixed payments, they have the potential to increase. Carrying a HELOC balance is similar to carrying a credit card balance in that regard.

If you have an existing HELOC, your best bet may be to try to pay it off as quickly as you can. If not, prepare to make some room in your budget for higher payments, because in light of recent interest rate hikes, they might soon start to climb.