How Home Equity Loan Interest Rates Work

A home equity loan is closed as either a standard second mortgage (much like a first mortgage) or as a home equity line of credit. Home equity loans have fixed monthly payments and a set term so that a borrower knows when the loan will expire. A home equity line of credit is a revolving loan that can be borrowed against, repaid and re-borrowed. Most home equity line of credit rates are based on an index--the prime rate and the Libor are common indexes. Fluctuating line of credit rates will change based on terms set forth in the closing documents.

The Terms

A home equity loan is closed as either a standard second mortgage (much like a first mortgage) or as a home equity line of credit. Home equity loans have fixed monthly payments and a set term so that a borrower knows when the loan will expire. A home equity line of credit is a revolving loan that can be borrowed against, repaid and re-borrowed. Most home equity line of credit rates are based on an index--the prime rate and the Libor are common indexes. Fluctuating line of credit rates will change based on terms set forth in the closing documents.

Amortization vs. Periodic Interest

The way in which interest is calculated is different between home equity lines of credit and home equity loans. A home equity loan is fully amortized based on the interest rate. A $50,000 home equity loan at a 6 percent interest rate and amortized over 20 years will result in a $358.22 payment each month for the life of the loan (240 months). A line of credit payment, however, will be based both on the current interest rate and the outstanding balance on the account. Periodic interest charges will vary depending on your rate and balance. Of course, larger minimum payments will be required if the full advance on the line of credit is obtained.

How Interest Rates Are Calculated

Both home equity interest rates and home equity line of credit rates are based on two factors: market conditions and creditworthiness. In times of economic strength, borrowers will find higher interest rates on both products. In times of economic uncertainty--such as the period following the 2008 credit crisis--borrowers will find low interest rates--a result of economists and the government trying to stimulate new borrowing.