How are HELOC rates determined?

Have you decided a Home Equity Line of Credit (HELOC) is the best type of loan for you? If so, it’s time to shop around for the best interest rate, which can vary from lender to lender. Keep reading to learn how HELOC interest rates are determined and what external factors affect them.

Key Takeaways

• Interest rates on HELOCs are determined by the prime lending rate plus a margin set by the lender. The prime rate is the lowest interest rate at which money can be borrowed, and is based on the federal funds rate, which is the overnight rate banks use to lend to one another.
• The federal funds rate is set by members of the Federal Reserve, the central banking system of the United States. When the Fed adjusts the federal funds rate, based on current economic conditions, the prime rate moves in accordance and affects HELOC rates.
• The margin set by the bank depends on your personal financial situation, including your credit score and Combined Loan-to-Value ratio (CLTV). The higher your credit score and lower your CLTV, the lower your margin will typically be.

Unlike the interest rate on mortgages or home equity loans, HELOC rates are adjustable rather than fixed. That means the rate will move up or down overtime based on the benchmark index it is tied to.

HELOC rates are based on two factors: A benchmark rate and your personal financial situation. Interest rates vary by lender, so make sure to do your research and shop around for the best rates before settling on a lender.

What is the benchmark rate?

Generally, lenders set HELOC rates based on the prime lending rate, which is the lowest interest rate at which banks will lend money to their most creditworthy clients, typically large corporations. While the prime rate varies from lender to lender, the one published daily by the Wall Street Journal is the most commonly used.

So, how is the prime rate determined? It is largely influenced by the federal funds rate, which is the overnight rate banks use to lend to one another. The federal funds rate is set by the Federal Open Market Committee (FOMC), which is composed of 12 members of the Federal Reserve, the central banking system of the United States. When the FOMC raises the federal funds rate, the prime rate moves with it, which also affects your HELOC rate.

The FOMC meets eight times a year to review current economic and financial conditions, and decide whether or not to adjust the federal funds rate and, if so, in which direction. If the committee decides to increase the rate several times in a row, your HELOC rate will increase significantly along with it. For that reason, it’s important to check what the maximum interest rate is for your line of credit before settling on a HELOC from any lender.

What is the markup or margin?

The primary factor banks use to determine the markup is your credit score. The higher your credit score, the lower the added margin and, therefore, the lower your HELOC rate will be. However, your Combined Loan-to-Value ratio (CLTV) also matters. The CLTV is the ratio of all secured loans against your property to its value. The lower your CLTV, the lower your rate will typically be.

The second factor influencing your HELOC rate is your personal financial situation, which determines the markup percentage, or margin, that your lender will add on top of the benchmark rate. For example, if the prime rate is 3.25% and your markup is 2%, your HELOC rate would be 5.25%.

The amount of money you want to borrow and the duration of your HELOC can also affect your markup. Lower amounts can lead to lower rates, as can shorter drawing and repayment periods.

HELOC rate discounts

Occasionally, you may see offers such as "prime+0%," or even negative markup offers like "prime-1%." This is typically an introductory rate, or limited-time offer, meaning your markup will increase after the discount period agreed upon by the lender. Before settling on an offer, make sure to check what the rate will be after this introductory offer ends, or you may be in for a hefty unexpected increase.

Fixed-rate option

Some lenders may allow you to convert part, or all, of what you've borrowed into a fixed interest rate during the closing or draw period. This may come with certain limitations, such as a time limit or minimum withdrawal limit. Make sure to talk to your lender about the opportunity of switching between adjustable and fixed interest rates.

Are you considering a HELOC but worried about increasing rates? The interest on the Aven HELOC Card never exceeds 18%, no matter how high the prime rate goes. Find out more and decide if it`s right for you!