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The Federal Reserve’s interest rate decisions influence the rates you pay for adjustable-rate mortgages (ARMs) and variable-rate home equity lines of credit (HELOCs).
At their meeting on Nov. 1, Fed officials announced that they will hold off on raising interest rates for now. However, as seen after recent past meetings, interest rates could still rise even if the Fed holds on adjusting its key rate.
“The Federal Reserve held off on another interest rate hike but is keeping their options open to raise rates at an upcoming meeting should conditions warrant,” says Greg McBride, Bankrate’s Chief Financial Analyst. “The rise in long-term interest rates in recent months has had the same desired effect of monetary tightening, effectively doing some of the Fed’s dirty work for them.”
Let’s break down how the Fed’s monetary policy affects ARMs, HELOCs and new home equity loans.
How the Fed affects ARM loans
Among its many responsibilities, the Federal Reserve sets the federal funds rate, the interest rate banks charge each other for overnight loans to meet reserve requirements.
In the mortgage world, the rates on ARMs are often 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 push the SOFR up or down. ARM rates, in turn, go up or down as well when the rate resets.
What ARM borrowers should know about the Fed
ARMs have variable interest rates. This means if the fed funds rate goes up, your ARM rate will increase as well at the next adjustment.
Some borrowers choose ARMs because the initial interest rate is lower than the rate on a fixed-rate mortgage, and they don’t plan on keeping the home for more than a few years — selling before the mortgage resets to a variable, usually higher, rate.
However, there are limits to, or “caps” on, how much your ARM rate can change:
- 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.
If you don’t know the caps on your ARM, you can find out by reviewing your closing documents or asking your servicer.
How does a Fed rate affect HELOCs?
The prime rate is another benchmark rate, usually 3 percentage points higher than the fed funds rate. When the Fed changes the fed funds rate, the prime rate moves up or down in tandem. Many lenders directly tie the rates on HELOCs and home equity loans to the prime rate, often adding extra percentage points onto them, for the ultimate rate you, the borrower, pay.
With rates over 9 percent, a home equity line of credit is no longer a cheap source of borrowing for home improvements or unplanned expenses.
— Greg McBrideChief Financial Analyst, Bankrate
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. If the fed funds rate goes up, your HELOC gets more expensive.
Home equity loans, on the other hand, come with fixed rates, so they aren’t as deeply impacted by fed funds rate movement. Once you close the equity loan, your rate won’t change.
If you want stability in your budget, know that with a HELOC, 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 line of credit overall.
Before you open a HELOC, understand the maximum interest rate, when the draw period ends and whether you’re responsible for interest payments only (or not) during this period.
If you already have a HELOC but don’t have a balance (in other words, haven’t drawn from it), rising rates won’t affect your wallet all that much. If you do owe, you’ll have a larger monthly payment to cover, usually within the next two billing cycles. This applies whether you’re in the interest-only or repayment phase.
With rates going up, you might want to explore whether you can lock in a fixed rate on a portion of your HELOC balance. This isn’t an option with every lender, and it might have some limitations if it is, however.
Bottom line on the Fed’s effect on ARMs and home equity
The Federal Reserve’s interest rate decisions affect borrowing costs for many types of financial products, including adjustable-rate mortgages (ARMs) and home equity loans and lines of credit (HELOCs). At its meeting on Nov. 1, the Fed decided to maintain its key rate — though a rate adjustment could still happen when officials meet again in December.
When the Fed raises its key rate, the rates on these variable-rate loans also rise, and vice versa. If you plan on taking out a home equity loan, an ARM or a HELOC — or already have one of the latter two — keep an eye on how the rates attached to them change following a Fed announcement.