How Does a HELOC Affect Your Credit Score?

Article Summary:

A home equity line of credit (HELOC) will appear on your credit report just like any other kind of loan or line of credit. Because of this, a HELOC will affect your credit score. Whether this effect is good or bad mainly depends on how you manage your credit line.

There are plenty of good reasons for getting a home equity line of credit. Perhaps your house needs some major repairs or you want to remodel. The money could also be used to finance college expenses, or for debt consolidation. You might even want to use the equity in your house for investment purposes, such as to make a down payment on a rental property.

While you could borrow money from a bank in the form of a personal loan for any of those reasons (or put it on a credit card), you can often get lower interest rates by taking out a HELOC. For one thing, you will likely get a more favorable interest rate because the loan is secured by your home. Read on to learn more about HELOCs, the pros and cons, and how getting one can affect your credit score.

What is a home equity line of credit (HELOC)?

A HELOC is a method of borrowing money against the equity you’ve built up in your house. How much equity you have will determine the size of the loan you qualify for.

Most banks will only let you borrow a certain percentage of your equity (roughly 60% to 70%, depending on your bank), and you will need to have a good credit history to get it. If you have $100,000 in equity, for example, you might be able to get credit up to $70,000 (perhaps a bit more), to use however you decide.

How a HELOC works

The nice thing about a HELOC is that, unlike a home equity loan, it’s a line of credit that can be drawn on as you need it. Home equity loans disburse the money as a lump sum payment whereas HELOCs offer you revolving credit much like a credit card but without the astronomical interest rates.

After you are approved for a HELOC, you have what’s known as a draw period, typically for 10 years. This means you are only allowed to draw on that line of credit for up to 10 years. That differs from cards where, as long as your credit card balances are in good standing, your revolving credit line is for life.

During the draw period, you can take as little or as much of the money as you need at any time and are only responsible for making interest-only monthly payments. However, you can choose to pay down the principal with your payments too if you want.

After your draw period is up, you can no longer access the line of credit and you usually have up to 20 years to pay off the remaining HELOC balance. At that point, your monthly payments will consist of both interest payments as well as the principal.

HELOC vs. home equity loan

It’s important to remember that another key difference between a home equity line of credit and a home equity loan, is that home equity loans usually have a fixed interest rate, meaning your monthly payments are predictable. A HELOC generally comes with a variable interest rate, which causes your payments to fluctuate.

Also, keep in mind that your home is used as collateral for your HELOC. This means you could find yourself in foreclosure and possibly lose your house if you fail to make your payments. Decide carefully if the risks are manageable enough to take on the extra burden.

How does a HELOC affect your credit score?

Any type of loan or credit account will have an impact on your credit score. Depending on how you manage that line of credit will determine if that effect is positive or negative.

For example, if you make timely payments on your HELOC, that will maintain or even improve your credit score. But if you fail to make on-time payments, that will likely prompt a dip in your score. With most types of revolving credit, even one late payment may cause lenders to report this to the major credit bureaus.

Here are a few other things to think about when determining how a HELOC increases or decreases your credit score.

Hard credit inquiry

Even if you have a fantastic credit report when you apply for any kind of loan or credit account, it results in a hard credit inquiry. That will cause your good credit score to drop a few points. However, the dip is temporary. So if you’re otherwise in good standing, it won’t affect your credit score significantly or long term.

Credit utilization ratio

Between your HELOC and other credit lines, it’s important to keep your credit utilization rate as low as possible. This means you shouldn’t use a high percentage of your available credit limit, which will hurt your credit score.

Furthermore, just because you have available credit on your HELOC doesn’t mean you need to use it all. Only borrow what you need at any given time, whether it’s for home improvements or college tuition, so you can allow for any unexpected expenses that might occur.

Additionally, banks will use revolving credit utilization calculations to decide if you’re eligible for a HELOC and what your interest rate will be. In other words, the lower your credit utilization ratio, the more likely you are to be approved for the loan and at a favorable rate.

Pros and cons of HELOCs

Home equity lines of credit can be a great financing option for homeowners looking to tap their property’s equity. However, as with most financing methods, HELOCs have risks as well as benefits.

WEIGH THE RISKS AND BENEFITS

Here is a list of the benefits and drawbacks to consider.

Pros
  • Lower interest rates. HELOCs allow you to access a revolving line of credit similar to a credit card but with lower interest rates. While credit cards had an average interest rate of 16.17% in early 2022, HELOCs tend to be considerably lower.
  • High credit limit. Since a HELOC is both secured by your home and a revolving credit line, you could potentially borrow a lot more than with an unsecured loan.
  • Borrow what you need. Unlike a personal loan, where you receive one lump sum, a HELOC allows you to borrow what you need when you need it. This flexibility can be a huge benefit if you have ongoing projects or aren’t sure what the final cost will be.
Cons
  • Home as collateral. Since your home secures a HELOC, missing your monthly payments could put your home in jeopardy of foreclosure.
  • Could decrease your credit score. Similar to other kinds of borrowed credit, missed or late payments will negatively affect your credit score.
  • Lower equity. Less equity in your home could be an issue if you need to sell it and home prices take a dive. It can take a long time to build up your home’s equity, so be sure it’s the right choice for you before getting a HELOC.
  • Hard to budget. HELOC payments are low during your draw period but rise significantly during the repayment period, which can make budgeting difficult. In addition to this shift, most HELOCs have variable interest rates, which could make your payments difficult to predict.

Is a HELOC a good idea?

Taking out a revolving line of credit on your home may or may not be a good idea, but it’s a decision you should carefully assess before applying. If, for example, you’re short of cash and using it to pay your bills, then a HELOC is essentially just adding another bill to your pile. This really won’t help your financial picture and may make things much worse for you down the road.

On the other hand, if you’re using some of the money to consolidate and pay off other debts, then it could be an excellent plan. It can improve your credit history and get you out from under high-interest credit card debt. Plus, if you feel confident that you will have enough money to make the payments, and you want to remodel your home or pay for your kid’s college, a HELOC might also make sense for you.

Either way, you will need to get approved for the loan first and this requires having good credit scores as well as a low debt-to-income ratio. If you can check those boxes, you might be in good shape to take out a HELOC. If not, you may want to take a closer look at your finances to improve your overall financial health before taking on more debt and jeopardizing your home.

To get a better idea of what a HELOC might offer you, take a look at some of the lenders below. By comparing your options beforehand, you’ll have a better understanding of what a HELOC may require and whether you have the appropriate budget.

How to improve your credit score before getting a HELOC

If you’re considering a HELOC for any reason, it’s a good idea to assess if this is a risk you can afford to take. The first thing you should do is take a good look at your credit reports from the three major credit bureaus — Experian, Equifax, and TransUnion. Everyone is entitled to a free copy each year.

You can use the information from your credit reports to get a clearer picture of how much debt you carry and how that measures up to your current income. Ideally, you want a debt-to-income ratio (DTI) of no more than 43%, though some lenders may require an even lower DTI.

You will also want to look at your overall credit scores. Basically, anything in the upper 600s or higher is considered good and will help to garner you lower interest rates.

However, if you find that your credit is less than stellar and don’t think you will be approved for a home equity line of credit, there are steps you can do to improve your score.

  • Pay off (or pay down) as much of your existing debt as possible
  • Always make on-time payments
  • Make sure you have a good mix of healthy credit (having too little credit can also hurt your score)
  • Consider getting a second job to lower your DTI

If you want some additional help improving your credit, or think you may have missed an error in your credit report, you may want to consider hiring a credit repair service.

Pro Tip

Before you apply to open credit accounts, check your free credit report to see if there are any accounts or inquiries you don’t recognize. It’s always a good idea to ensure your credit information is up to date and accurate.

The no-debt alternative to HELOCs

If you are in the market for a HELOC but you’re concerned about how it will affect your credit or you’re not sure you can afford the extra monthly payments, there are alternatives to consider. For instance, shared equity agreements allow you to unlock your home equity without charging interest or monthly payments. They are also easier to qualify for than traditional home equity products, such as home equity loans and HELOCs. See how much you could get today for a share of your home’s future appreciation.

We recommend you apply with the following companies and see which one offers the best terms. It is free and won’t hurt your credit.

FAQs

What are the disadvantages of a home equity line of credit?

The biggest disadvantage of a HELOC is that your house is used as collateral for the loan. If something happens, like a job loss or illness, and you suddenly can’t make your monthly payments, you could lose your home.

Does a HELOC go against your credit?

Not automatically. In fact, a HELOC can actually help your credit score. For example, if you have a HELOC but don’t use much of your line of credit, it can actually decrease your overall credit utilization rate which is beneficial to your credit score.

Does a HELOC hurt your debt-to-income ratio?

Similar to your credit utilization ratio, running up your HELOC will impact your DTI if you use too much of the available credit that’s been extended to you. However, again, if you don’t max out your line of credit, it could actually help your credit score by improving your debt-to-income ratio.

Key Takeaways

  • A home equity line is a type of revolving credit that typically comes with a draw period of 10 years.
  • During your draw period, you are only required to make interest payments. Afterward, your monthly payments can fluctuate due to variable interest rates.
  • Like other loans, late or missed payments will affect your credit report negatively.
  • Making timely payments and keeping your credit utilization ratio low can improve your credit score.
  • If your financial situation is precarious, taking out a HELOC could put you at risk of losing your home.
View Article Sources
  1. Home Equity Loans and Home Equity Lines of Credit – Federal Trade Commission
  2. What is a Home Equity Line of Credit (HELOC)? – HelpWithMyBank.gov
  3. How to Tap Into Your Home Equity Without Getting Into Debt – SuperMoney
  4. Should You Use a HELOC to Pay Off Credit Card Debt? – SuperMoney
  5. The Complete Guide to HELOCs: Everything You Need to Know About Home Equity Lines of Credit – SuperMoney
  6. How Long Does It Take to Get a Home Equity Loan? – SuperMoney
  7. Best HELOC Lenders | June 2022 – SuperMoney