When applying for a home equity loan, you’ll need to decide whether you want to be charged a fixed percentage or prefer to take your chances on interest rates in the wider economy. Borrowing costs on these loans are typically fixed, although some lenders do offer adjustable options.
The fixed versus variable debate isn’t one to shrug off. Borrowers ought to be aware of the difference because choosing one over the other could drastically alter their finances and mental well-being. But the answer isn't simple and straightforward; each choice has its benefits and drawbacks.
- Home equity loans are typically charged at a fixed interest rate, although some lenders do offer adjustable options.
- This choice can affect your monthly payments and the total cost of your loan over time.
- A fixed-rate loan has the same interest rate for the duration of the borrowing period, whereas variable rates can move up and down.
- The certainty offered by fixed borrowing charges comes at a cost: higher initial fees and the potential to pay more for the entire duration of the loan.
- A variable rate starts out cheaper and could save you a fortune, but it can also result in unmanageable borrowing costs, default, and foreclosure.
What’s the Difference Between a Fixed and Variable Rate?
When you take out a loan, it’s common to pay the lender something extra on top of the amount borrowed to make it worth their while. This charge is what refer to as interest, and it can be either fixed or variable.
A fixed-rate loan applies the same interest rate for the duration of the borrowing period. The cost to borrow the money is set before you agree to take on the loan and remains the same until the debt is repaid unless otherwise specified.
Variable-rate loans work in the opposite way. When taking this path, borrowing costs periodically fluctuate, moving up and down.
Variable rates are tied to the movements of a specific financial index tasked with reflecting how much the wider economy is paying for credit. The index on which your loan is based will be listed in your loan documents. Common benchmarks include:
- The one-year constant maturity Treasury (CMT)
- Federal Cost of Funds Index (replaced The 11th District Cost of Funds Index (COFI) as of January 2022)
- The London Interbank Offered Rate (LIBOR)
- The Wall Street Journal prime rate
Pros and Cons of Fixed-Rate Home Equity Loans
The most obvious benefit of a fixed-rate home equity loan is certainty. Before you sign the contract, you’ll know exactly what your monthly payments will be as well as the total borrowing costs.
Fixed rates make budgeting easier and can reduce stress. Choose this option and you’ll know for certain how much to put aside each month. You won’t be in for any surprises—good or bad.
Unfortunately, this certainty comes at a cost. With a fixed-rate loan, you will likely start out paying more than you would on a variable one. Playing it safe commands a slight premium because it is a popular choice and can end up leaving the lender out of pocket if inflation soars.
Of course, the odds could also work against you. Many people opt for fixed-rate loans because they are scared their repayments might go up. However, there is also a decent chance that the variable rate will leave you better off.
If rates fall, you do have the option to refinance the loan, although there may be a penalty for doing so.
Pros and Cons of Variable Rate Home Equity Loans
The main attraction of a variable-rate loan is that it can save the borrower quite a bit of money. Should inflation and interest rates fall and then remain low for the duration of the loan, the amount you’re charged to borrow could be significantly less. On the other hand, as 2022 has demonstrated, interest rates could rise and make your loan more expensive.
One thing that’s at least pretty much guaranteed is a lower initial borrowing cost. If, for example, a lender offers a fixed rate of, say, 6%, its variable rate will usually begin several percentage points lower. Barring economic conditions drastically changing at the outset, it’s possible that the variable rate will remain cheaper for a while, potentially yielding significant savings at the very time when the loan balance on which you’re charged a percentage is at its highest.
It’s the not knowing that kills most people. Yes, the savings can be notable with a variable rate. However, there’s also a chance that the cost of living skyrockets, interest rates soar, and your loan repayments suddenly balloon and become unaffordable. Should that happen, you may lose the home you put up as collateral.
Without a crystal ball, there’s no saying how expensive your loan will be in the future. Some people are willing to take their chances, while others have limited financial flexibility and prefer to play it safe.
Which Should I Choose?
There’s no right answer to this question. Both strategies have merits.
If you’re confident that interest rates will go down in the future and have enough money tucked away to absorb any potential upsets, a variable rate is probably your best option. This may also work if interest rates are especially high, making the lower initial rate of a variable loan more appealing. Going with fluctuating charges can also make sense if you're planning to pay off the loan quickly, thanks to the more appealing introductory rates.
Of course, in a rising interest rates market, rates could go even higher. If the thought of not knowing how much you’ll owe in the future makes you uneasy, you should probably choose the fixed option. Certainty may come at a high price, but sometimes the peace of mind it affords is worth every cent.
What Is the Benefit of a Fixed-Rate Home Equity Loan?
Certainty. When you opt for a fixed rate, you know exactly how much you will be charged and can budget for it without having to worry about the possibility of rising interest rates.
Are There Closing Costs on a Home Equity Loan?
Yes. As with most other real estate transactions, home equity loans are subject to closing costs. The amount you pay depends on the lender and generally ranges from 2% to 5% of the loan value.
How Do You Determine Your Home Equity?
The Bottom Line
One of the most important choices when taking out a home equity loan is whether to opt for a fixed or variable rate. This decision needs careful consideration because it can affect your finances—and blood pressure—for years to come.
The cash that home equity loans provide can help make your dreams come true. However, those dreams can quickly turn into nightmares if you walk into this transaction carelessly and choose the wrong method of repayment.