If you are shopping a home equity loan or home equity line of credit (HELOC:), here is some good news. Now when Federal Reserve has started to lower interest rates, home equity loan and HELOC rates are expected to drop.

Due to the steep rise in mortgage rates over the past few years, home equity loans have become an attractive alternative to cash-out refinancing.

"Home equity loans allow homeowners to access their equity without affecting their prime mortgage rate, which for many is much lower than today's mortgage rates," they said. Rob CookCMO at Discover Home Loans.

Whether you're tapping into your home equity consolidate debt or finance a large projectYou need to look for the best loan terms. However, it is not completely under your control. Interest rates are affected by several factors. Some are personal, like your credit score, but others are not, including central bank decisions about monetary policy.

You don't have to be an expert, but some basic knowledge can help you get the most out of your equity.

Home Equity Loans vs. HELOCs

Home Equity Loans allows you to borrow money against your home for a lump sum of cash.

Home equity lines of credit act more like a credit card. You can increase or decrease the balance up to a certain limit, rather than receiving all the cash at once.

In in both casesyou will need sufficient propertywhich is measured as the difference between your mortgage debt and the current market value of your home.Both products act as a second mortgage using your home as collateral for the loan.

The role of the Fed and interest rates

As the U.S. central bank, the Federal Reserve is "designed to help maintain economic stability," it said. Jacob Channel, Senior Economist at LendingTree.

The Fed sets a benchmark interest rate, the federal funds rate, that affects the rate banks charge for all types of loan products, including home equity loans and HELOCs.

The Fed doesn't directly set rates on home equity loans or lines of credit.The rates you see for home equity products usually change with the benchmark rate, which is why they've been exceptionally high lately.

After raising the federal funds rate several times since 2022, the Fed is now reversing course to cut rates. So far, the Fed has cut rates three times. the latter by 0.25% on December 18.

The idea is as follows. high interest rates discourage people from spending and borrowing, while low interest rates encourage it.In a weaker economy, the Fed will low rates to stimulate economic activity. With a growing economy, the Fed will raise interest rates to prevent inflation.

The Fed's rate cut makes borrowing cheaper

If the Fed lowers its benchmark rate, banks will eventually lower their rates on new home equity products, and vice versa, but "the relationship is not necessarily one-to-one," Channel said , such as the labor market, can also affect the rates set by banks.

There is also a difference in how Fed policy changes affect HELOCs versus home equity loans.

HELOCs:When the Fed lowers interest rates, homeowners with existing HELOCs and those looking to take out a new line of credit benefit. Home equity lines of credit typically have variable interest rates tied to a prime rate that goes up and down When the Fed cuts rates, it eventually drops to the rates offered by existing HELOCs and lenders.

Home Equity LoansIf you currently have a home equity loan, your interest rate will not change with the Fed's latest cut. With home equity loans, your interest rate will be fixed at the time you close on the loan, regardless of how the Fed adjusts rates later. However, interest rates on new home equity loans will reflect any policy changes by the Fed.

Channel expects that as the Fed implements more rate cuts, this will translate into a gradual decline in interest rates across the economy, including for home equity loans and HELOCs, mortgages and cash-out refinance loans.

Why is the Fed lowering interest rates?

In the early days of the pandemic, when the economy stalled, the Fed lowered interest rates as much as possible. The idea was to encourage people to keep spending during a weak economy, and that prompted banks and lenders to set historically low mortgage rates. 2% or 3% down.

As the economy began to recover and inflation picked up, the Fed began raising interest rates to slow price growth. High interest rates also led to higher home equity rates. In 2021, home equity rates were as low as 4.4%, and by the end of 2022 they were were approaching 8%. average home equity rates are in the middle range of 8%.

As inflation began to cool consistently, the Fed began to cut interest rates.

After its latest rate cut, the central bank is likely to move cautiously with occasional 0.25% cuts over the coming year, depending on how the economy fares under the next administration.

Other factors affect home equity rates

The Fed's benchmark interest rate isn't the only thing that affects the interest rates you can get for a home equity loan, or HELOC. Here are some other factors that can change the rate you qualify for:

Your personal financial profile. Banks give their best rates customers with high credit scores because it shows that they have a history of repaying the debt on time is your only debt, you'll likely get a better interest rate than if you have a lot of credit card or student loan debt, for example.

How much property do you have in your home? Lenders will usually allow you to borrow up to 80% or 90% of the value of your home. For example, if your primary mortgage is already 75% of your home's value, banks will likely charge you a higher interest rate than if your mortgage is only 40% of your home's value, leaving a lot available equity capital to borrow against. Likewise, borrowing less than your available equity is one way to potentially lower your home equity loan or HELOC interest rate.

Which bank or lender do you use? Various lenders will offer different prices, which is why it pays for 24/7 shopping and get multiple quotes before taking out a loan.

How to determine if you should tap your home equity

If you are connected leverage your home equity sooner rather than later taking out a new HELOC can be beneficial as its adjustable rate will likely decrease as the Fed implements more rate cuts. Just remember that interest rates may also rise in the future based on the economic outlook, which means less predictability for your payments.

Depending on your personal goals and needs, you can undertake a fixed rate home equity loan after a few months, when interest rates will likely be lower.The home equity loan rate is fixed at the beginning, so you would like to miss out on further declines in interest ratesbut you will be insulated from any potential rate hikes in the future.

If you have already borrowed against your equity, the same principle applies. You may see your adjustable HELOC rate drop with the Fed's rate cuts in the coming months, but the fixed rate on your home equity loan will not change.

Basically, how you use your equity to finance it depends on why you need the money credit cardsthen home equity rates are now already improving.

Even a good interest rate home equity loan or HELOC always involves some risk. Both products are debts secured against your home, which means that if you default on the payments, the bank can foreclose on your property.