Some borrowers mistakenly believe that federal rate cuts have a direct affect on their HELOC interest payments. In reality, federal rate cuts are a move by the government meant to promote economic stimulus. These federal cuts are generally followed by a prime rate cut. However, the Federal Reserve does not have the power to change the banks’ prime rate itself.
To understand how this works, you’ll need to comprehend three terms: index, prime, and margin.
Understanding Indexes
Under federal law, your lender must base your HELOC interest rate on a publicly available index. An index is a published interest rate that lenders use to measure the difference between the current adjustable rate they are offering customers and the interest rates that other investments are earning. If the selected index decreases, HELOC lenders lower their interest rates. If the index goes up, HELOC lenders increase their interest rate.
Popular indexes used for HELOCs and home equity loans include: the London Inter Bank Offering Rate (LIBOR), the Treasury Bills (T-Bill), and the Prime Rate.
Understanding the Prime Rate
If you have typical United States HELOC, chances are high that your interest rate is based on the prime rate. (Check your loan documents to find out – using the prime rate is common but not always the case). The prime rate is the rate at which the majority of North American banks lend to their most credit worthy customers. Banks generally decide their prime rate by using the Federal Funds Rate (the interest rate that banks charge each other for overnight loans made to fulfill reserve funding requirements). The Federal Funds Rate is determined by the Federal Open Market Committee, which meets eight times a year. Generally, banks end up setting the prime rate about 3 percentage points above the Federal Funds Rate.
The majority of banks change their Prime Rates at the same time. When at least 75% of the country’s 30 largest banks change their rates, the Wall Street Journal publishes the new prime. You can view the current Prime Rate on their website. The Federal Reserve also posts its own list of historic prime rates.
Understanding Margin
The margin is the difference between the prime rate (or whatever index rate your HELOC uses) and the interest rate the borrower will be charged. If the current prime rate is 5% and your margin is 1, you will be charged 6% interest. If your margin is 3, you will be charged 8% interest. The margin is the last step in determining your actual rate. Fortunately, this is a number that cannot be changed throughout the life of your HELOC.
Index Rate + Margin = Your Interest Rate
Federal Rate Cuts as a Lender Incentive
When there is a Federal Funds rate cut, lenders often follow by cutting the prime rate. However, they may choose not to. If the federal rate is decreased, banks will make more money by keeping the consumers’ prime rate the same. If the lending market is slow, however, it is often in the banks’ interest to increase business by cutting the prime rate.
When Does Your HELOC Adjust?
If the prime rate is cut, you may not see a difference in your monthly bills immediately. Check your home equity loan documents to see how often your interest rate adjusts. You may be stuck with the previous rate for a month, a quarter, or even a year.
See Also: