The Federal Reserve’s interest rate decisions affect the interest rate you pay for home equity loans, HELOCs, and adjustable-rate mortgages (ARMs). Following its May meeting, the central bank announced it would raise its key interest rate by 0.5 percentage points, a sign that further rate hikes are likely to fight inflation by the end of the year. If you have an adjustable rate loan, you should understand the stakes.
The Federal Reserve is also scaling back its massive asset-purchase program, which has helped keep interest rates low. The move is also expected to put upward pressure on mortgage rates. The Federal Open Market Committee held its regular two-day meeting on May 3-4.
The Fed’s Impact on Home Equity Loans, HELOCs, and ARMs
The Federal Reserve is responsible for setting the federal funds rate, with which banks charge each other overnight loans to meet reserve requirements.
- Home Equity Loans and HELOCs: The federal funds rate is another reference rate that tends to be 3 percentage points higher than the federal funds rate. Many lenders tie rates on home equity loans and HELOCs to the prime rate. When the Fed changes the federal funds rate, lending rates, including the federal funds rate, go up or down based on the Fed’s decisions.
- ARM: Many ARM rates are now pegged to the Secured Overnight Funding Rate (SOFR), which has replaced the London Interbank Offered Rate (LIBOR). Since the Fed’s interest rate decisions are the basis of the savings facility, an increase or decrease in the federal funds rate can cause the SOFR to increase or decrease, which means that the ARM rate also increases or decreases, depending on when the loan matures and resets the rate.
What ARM Mortgage Borrowers Should Know About the Fed
ARMs have variable interest rates that fluctuate up and down with the federal funds rate. This means that if the federal funds rate increases by a quarter of a percentage point, your ARM rate will also increase at the next reset. However, there is an upper limit to how much you are interested in.
There are three types of rate limiting:
- Initial Adjustment Cap: If the rate increases after the end of the fixed rate period, this is the maximum rate for the ARM. Usually 5 percent is the maximum amount.
- Adjusted Cap: This is the initial adjusted maximum rate.
- Lifetime Adjustment Cap: The highest interest rate you can charge over the life of the loan.
Make sure to find out what the upper limit is before getting an ARM. Some borrowers choose ARMs because interest rates are lower than on fixed-rate mortgages, and they don’t plan to keep their home for a few years at most.
What HELOC Borrowers Should Know About Fed Home Equity
Because HELOCs typically have variable interest rates, borrowing costs can rise or fall with the federal funds rate. So when the Fed raises interest rates, your loan becomes more expensive, usually starting with the next month’s payment.
HELOCs can be stressful for borrowers who want price certainty, as there is no real way to predict whether rates will rise, fall, or stay the same. Not only does your interest rate affect your monthly cost, but it also has a significant impact on the amount you pay for the entire loan.
Before considering a home equity loan, such as a HELOC, borrowers should consider their budget. A financial advisor can help discuss options and how getting a home equity loan could affect ones financial situation. Your lender should tell you the maximum interest rate on the loan, when the repayment period begins, and whether or not the payment is only interest during the draw period, which can be up to 10 years.
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