Home Equity Loans vs. Interest Rates

It seems every day I am talking about interest rates increasing. Unfortunately, this is the story of our generation. Most of us have not seen 8-10% inflation and 6-10% mortgage rates.

But we are here now and need to take these developments seriously. If we continue to consume and enjoy life at face value, we can quickly dig ourselves into a hole. 

America’s bailout. For over 20 years, home equity has been the bailout plan for most Americans. What is a bailout plan?

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When you need money, you can TAP your home equity to get a quick influx of cash. The idea is that once you need another infusion of money, your home value will have appreciated further. 

The 2005 Gold Rush. I witnessed the gold rush of home equity in 2005 when my mom lived in San Diego. I was a young military man working overseas at the time.

When I came home to visit my mom in San Diego, every house had two nice cars, boats, ATVs, jet skis, RVs, and motorcycles.

I remember asking myself, “What am I doing wrong?” Well, it turns out everyone was on a home equity sugar rush.

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Home prices in California doubled every 3-5 years, and people were cashing out via home equity loans, and cash-out refinances. 

The Great Recession. In 2008 and 2009, home prices crashed hard. No more home equity to leverage, and most people didn’t know how to create money.

Home prices grew from the low point in 2009 and then shot up in 2020 after the pandemic. However, 2022 has been a crazy year for interest rates, which may put home equity out of reach. 

Home equity versus interest rates. Almost everything in the economy runs on interest rates. There is an initial interest rate that starts the valuation process—the Federal Funds rate.

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The Federal Reserve sets its benchmark rate with the intent to maintain inflation at around 2% a year and keep employment as high as possible. 

The bond market begins to bid the rest of the interest rates up and down from the Federal Reserve rate. The bond market bases these rates on risk to principle. 

Here is a rough order of the risk profile of bonds. Read “The Bond Book” to further understand bonds, as they are vital to our economy. 

1. Federal Funds rate
2. 2, 5, 10, 20, 30-Year Treasury Bonds
3. Corporate Bonds
4. Mortgage-Backed Securities
5. Municipal Bonds
6. Junk Bonds (high-yield corporate bonds)
7. Dividend-paying stocks (compete with bonds)

How cares about bonds? So what do bonds have to do with your home equity loans? At some point, bankers will place home equity loans into high-yielding securities to sell to bond investors.

Personal secondary debt is extremely risky compared to Treasuries and Mortgage-backed securities. So the home equity security will need to compete for investor bucks.

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If the Federal Funds rate is 3%, mortgages are 6%, and junk bonds are 7%, what interest rate will attract investors to home equity loans? Probably 10-12%.

The comparison game. Home equity loans are risky because they could be the first debt homeowners STOP paying. That means investors have to assume the risk, which increases consumer interest rates.

Should you take a home equity loan? You have to make some big predictions to take a home equity loan. Here are your two most prominent questions.

1. Will home prices crash?
2. What direction will interest rates move?

Will the housing market crash? If you think the housing market will crash, you may want to take a home equity loan. If you have $100,000K in home equity, it may decrease to $20,000 or less. 

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You will not be able to take a home equity loan if your home prices fall to a certain level. Again, that’s a huge assumption you will have to make. 

What direction will interest rates move? Home prices and mortgage rates have an inverse relationship. One goes up, and the other goes down.

Here is an easy way to remember this relationship. Say the average person can afford $2,000/month for their home.

They can either afford an expensive home with a low-interest rate or a cheap house with a high-interest rate. Now you will need to predict the direction of interest rates to determine how home prices will react. 

My two cents. An investor should always have an analysis of the situation. It’s good to take in guidance from others, but form your own opinions and trust your instincts. 

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I think the Federal rate will sit around 4-5% for a year. That means mortgage rates will remain about 6-8% for a year or two. 

I don’t foresee house prices crashing too hard. Housing is still scarce, rents are high, and people are still willing to pay top dollar to get into a home. 

I would not take out a home equity loan over the next two years. House prices may stabilize, but the economy will crash around us. 

People will lose jobs, big companies will shrink, small companies will disappear, joining the military will make a comeback, car prices will crash, and people will start returning to work.

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Conclusion. The article was a small taste of the bigger world of interest rates. As you can see, home equity loans and mortgage rates are part of a bigger ocean of rates.

These policy shifts are beyond our control, but what can we control? We can control our recession budget, debt levels, and how we save and invest.

If you fear losing your job, start creating content or joining the gig economy. Better yet, rent a room. Good Luck!

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