The Federal Reserve’s interest rate decisions influence the rates you pay for adjustable-rate mortgages (ARMs), home equity lines of credit (HELOCs) and home equity loans.

Beginning in 2022, the Fed embarked on a mission to fight high inflation by increasing interest rates. That policy has continued into 2023, with the central bank raising its benchmark borrowing rate by another quarter-percentage point at its May 3 meeting. The federal funds rate has now reached its highest target range since August 2007.

Fed influence on home equity loans, HELOCs and ARMs

The Fed is responsible for setting the federal funds rate, the interest rate banks charge each other for overnight loans to meet reserve requirements.

  • ARMs: Rates on many ARMs are tied to the Secured Overnight Financing Rate, or SOFR. Because the Fed’s rate decisions serve as a basis for savings instruments, raising or lowering the fed funds rate can cause SOFR to go up or down, meaning ARM rates will go up or down as well, depending on when the loan resets its rate.
  • HELOCs and home equity loans: The prime rate is another benchmark rate, and it tends to be 3 percentage points higher than the fed funds rate. Many lenders tie the rates on home equity loans and HELOCs to the prime rate. When the Fed changes the fed funds rate, loan rates, including the prime rate, move up or down in tandem.

What ARM mortgage borrowers should know about the Fed

ARMs have variable interest rates which float up or down with the fed funds rate. This means if the fed funds rate goes up by a quarter of a percentage point, your ARM rate will increase as well at the next reset. However, there are caps on the amount of interest you’re on the hook for.

There are three types of rate caps:

  • Initial adjustment cap: This is the maximum interest rate on an ARM, if the rate rises, after the fixed-rate period ends. Usually, 5 percentage points is the maximum amount.
  • Subsequent adjustment cap: This is the maximum rate after the initial adjustment.
  • Lifetime adjustment cap: This is the maximum interest rate you can be charged over the entire span of the loan.

Be sure to find out what the caps are before you get an ARM. Some borrowers choose ARMs because the initial interest rate is lower than fixed-rate mortgages’ and they don’t plan on keeping the home for more than a few years, at most — selling before the mortgage resets to a variable, usually higher, rate.

What home equity borrowers should know about the Fed

Because HELOCs usually have variable interest rates, the cost of borrowing can rise or fall with the federal funds rate. When the Fed raises the fed funds rate, your loan will get more expensive, usually starting with the next monthly payment.

For borrowers who want price certainty, a HELOC can be stressful as there’s no real way to predict whether rates will rise, fall or stay the same. Not only does your interest rate affect monthly costs; it can also greatly impact how much you pay for the loan as a whole.

Home equity loan and HELOC borrowers should consider their budget before they borrow against their home equity. Before you open a HELOC, talk to your lender about the maximum interest rate, when the draw period of the loan ends and whether payments are interest-only during the draw, which is often 10 years.