Many homeowners have recently seen the amount of equity they have in their homes increase.
According to Lendingtree.com, an average of 16.85% of homeowners considered a home equity loan or HELOC. And with home prices in many parts of the U.S. have risen dramatically. Because of this, it’s no surprise that millions of Americans considered a home equity loan or home equity line of credit (HELOC) in 2021.
Like any debt, that money needs to be repaid. So, does a HELOC affect your credit? The simple answer is IT DEPENDS.
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Yes, a HELOC Will Reduce Your FICO Score — But It Might Be Worth It
However, if the loan is managed properly or helps you consolidate debts, it will end up helping your FICO score over the longer term, particularly if you’ve been missing monthly payments or racking up a lot of late payment fees.
READ MORE: Why did my credit score drop?
How a HELOC Works
A HELOC is a revolving line of credit using the equity that a homeowner has available in their home to be granted a credit line. The lender will take the value of your home minus what you still owe on your mortgage to establish the amount of equity you have built up in your home. You can then apply to borrow up to 80% minus closing costs.
When a homeowner applies for the HELOC, it goes through underwriting since your home is used as collateral for approval. Once approved, a homeowner typically has a draw period of up to 10 years. During this time, the homeowner can make purchases, pay off debt, etc., just like they would with any other credit card.
During the draw period, interest payments are required until the draw period ends. Once the draw period ends, the monthly charge minimum payment amounts increase as the payments switches from interest only to interest/principal for the repayment duration.
What are the differences between a home equity loan and a HELOC? In short, a home equity loan is a fixed-rate loan that’s issued in one lump sum, while a HELOC is a revolving line of credit that works like a credit card. The Federal Trade Commission (FTC) offers some helpful guidelines.
How Will a HELOC Affect Your Credit Score?
A HELOC, or home equity line of credit, is a revolving line similar to a credit card. The utilization ratio plays the most significant factor in how a HELOC affects your overall credit score. There may be a slight negative impact when initially applying for one. Still, suppose the credit utilization ratio is kept under 30% of the available credit limit, and the repayments are made on time. In that case, it can have an overall positive effect on your credit score.
READ MORE: Which credit report, score or bureau is most accurate?
Credit Score Requirements for HELOC approval
The HELOC approval process is similar to getting approved for a mortgage. Lenders will run a hard inquiry on your credit report, which usually has a short-term negative impact. A good credit score falling somewhere in the mid-600s or higher will likely be required for eligibility, though there are some lenders that offer home equity loans to borrowers with bad credit.
READ MORE: What credit score do you start with?
Other Requirements to Consider
As lenders review your credit history profile, things like on-time payments, payment history, and the HELOC loan amount come into play for approval. You’ll also need:
- A debt-to-income ratio of 43% or less is ideal. Some lenders will allow a DTI of up to 50%.
- To qualify for a HELOC, generally, you need a loan-to-value ratio of 80% or 15-20% equity in your home. But it is best to keep this at a maximum of 80% to avoid paying private mortgage insurance.
READ MORE: Simple ways to build home equity
Breaking Down a HELOC’s Impact on Your Credit
Most HELOCs have fluctuating interest rates, meaning monthly payment amounts will vary over time. Sometimes your payment may be higher. Sometimes it may be lower. It all depends on current interest rates.
Step One: Applying
Opening your HELOC and getting approval could have a short-term negative impact because your credit report will be pulled.
The hard credit pull from your loan application will have a minimal impact on your credit score, but expect it to drop by a few points. How much your credit score drops will depend on the last time you applied for credit.
Step Two: Making Payments During the Draw Period
Once you have been approved and your HELOC is established, how you maintain it will determine its overall effect on your credit.
For example, let’s say your HELOC is $10k; in the first couple of years, you never spend more than $2,500. Low usage would positively affect your credit because you are staying under a 30% credit utilization rate and your overall creditworthiness is worth an extra $10,000. If you were to max out your HELOC at $9,999, this could have the opposite effect on your credit score because your credit utilization rate will be higher.
While the draw period is open, usually about ten years, you are only required to make interest payments. Keep this in mind as you spend money on your HELOC, because this will affect your credit utilization ratio.
That credit utilization number will determine whether your HELOC will negatively impact your credit. If you aren’t using much of your available HELOC balance or you are quickly and reliably paying back what you use, your score probably won’t be affected much. If you have a high balance on your HELOC and are making interest-only payments, your credit score could drop significantly.
Step 3: Making Payments AFTER the Draw Period Ends
Once the draw period ends, you will be required to make payments on the interest and the principal combined over the remaining loan term, which can be as long as 20-30 years. This means your minimum payments will increase if you still carry a balance.
If you cannot make those payments, your credit score will drop as you become further behind on payments and can put your home at risk of foreclosure.
Remember, during both repayment periods, you only pay interest on the amount of the HELOC you have used, not the total amount you have available.
Step Four: Closing Your HELOC
Closing your HELOC could lower your credit score because once the account is closed, it is the same as closing a credit card. From our example, you would lose $10,000 of your total available credit.
Exactly how much it drops will depend on your other revolving accounts. If you have other credit lines open, your credit score could drop slightly. If your HELOC was your only credit line, that drop will be much more significant.
Things to Consider Before Applying for a HELOC
Two of the most significant deciding factors when deciding if a HELOC is right for you is considering the interest rates and repayment.
- Interest rates: Interest rates on home loans are unusually high right now, and the loan could get more expensive if the loan rates rise even more. However, the rates can be lower than rates for most personal loans.
- Repayment: Are you are confident in your ability to repay the amount you borrow against your home? You could lose your home to foreclosure if a default on payment occurs.
- Reasons for the loan: How do you plan to use the money? Is it for debt consolidation, which could end up helping your credit score in the long run? Or are you looking to make home improvements or renovations, which may not help your credit score, but could increase your home’s value.
- Potential tax savings: Will the interest be tax deductible?
Thinking about a HELOC? Check out this video to learn more about when NOT to do it.
The Next Steps
If a HELOC is right for you, there are a few more steps before you complete the application.
Find out:
- How much your house is worth
- How much you still owe on your mortgage
- How much equity you have
Check your credit report to understand your chances of being approved or denied. If your score needs some improvement, consider putting off the application for a few months while you take some easy steps to boost your credit score.
Above all, compare lenders and rates. Don’t let anyone pressure you into a loan you may not be comfortable with or may not be able to afford. Don’t proceed until all your questions are answered.
READ MORE: How to get a free credit report
Other Debt Consolidation Loan Options
The Bottom Line
HELOCs are a cheap way to borrow cash using your home as collateral. As with any loan, the borrower should weigh the pros and cons of taking out any loan.
You will want to understand how this loan works, what your interest rate is, how and when it may change, how you plan to use the money and run calculations to see how much you can afford to borrow at the various interest rates and how much you will be paying over the life of the loan.
FAQs
Add up all your credit card balances, then add up all your credit limits, divide your total credit card balances by the total credit limit and multiply this by 100 to get it as a percentage.
Example: You have two credit cards with $1000 each as maximum credit lines. Your total credit limit is $2000, and you have a $300 outstanding balance on each card. $600/$2000= .30 X 100= 30% is your credit utilization.
HELOCs have a lot of benefits and a few big drawbacks. Pros flexible loan amounts and a revolving line of credit. Cons include the variable interest rate and the risk of racking up debt you can’t afford to repay. Learn more about HELOC pros and cons.
No, a home equity loan — also called a second mortgage — is where you can use your new lender to take out a new home equity loan and use the proceeds from that loan to pay off your original home equity loan. Ideally, the new loan would have a lower interest rate, a lower monthly payment, or provide access to more cash. If your home’s value is high enough, you may be able to borrow enough to pay off your existing mortgage.
A HELOC is a home equity line of revolving credit. Unlike a conventional loan, you establish a home equity line of credit ahead of time and use it when and if you need it. It works like a credit card. In both types of loans, your home is used as collateral.
A HELOC will have an adjustable interest rate, and you’ll only pay interest on the money you use. The loan will have a credit limit and a set time frame, or “draw period,” usually ten years. During that time, you can continue to borrow even as you make payments.