Many owners have more equity in their home today than two years ago, thanks in large part to soaring home values during the coronavirus pandemic. For many owners, this is a good time to consider home equity line of creditor HELOC, to access funds at a lower interest rate.
Like most loans, a HELOC can impact your credit score positively or negatively depending on how you repay it. That’s why it’s important to make regular, on-time payments to avoid any negative impact on your credit score.
Here’s what you need to know about HELOCs, their impact on your credit score, and whether they’re a good option to consider when accessing your home equity.
What is a HELOC?
A HELOC is a loan that allows you to borrow against the equity you have accumulated in your home (the more mortgage payments you have made over the years, the higher the equity in the home you have). A HELOC is a revolving line of credit that works like a credit card, but also has a draw period (usually 10 years) which allows you to continuously withdraw money over time as needed. One of the benefits of a HELOC is that you can make interest-only payments during your drawdown period, which means you can borrow a large sum of money over a long period of time while making only minimum monthly payments.
The interest rate on a HELOC, however, is variable, meaning your monthly payments can fluctuate with changes in interest rates and the economy. If you’re considering a HELOC, be sure to budget accordingly for a range when planning your monthly payments.
What is a credit score?
A credit score is a three-digit number that lenders use to gauge the likelihood of you repaying a loan. The higher the number, the better the score. The FICO score, one of the main credit scoring models, ranges from 300 to 850 and is divided into five levels ranging from very bad (300 to 579) to good (670 to 739), very good (740 to 700 ) and excellent (800 to 850).
A credit score is based, in part, on your credit report and overall credit history, but an important factor is your payment history, which accounts for 35% of your credit score. To qualify for great credit, you must make regular and on-time loan payments to prove that you are responsible and reliable in repaying the loan on time. If you make late payments, your credit score will drop and lenders will consider you a credit risk, penalizing you with less favorable loan terms, including a higher interest rate.
Credit reporting agencies collect information such as your payment history, credit usage (or the amount of available credit you’ve used), length of your credit history, and types of loans and credit cards in use. . All of this information is used to determine your FICO score. Whether you have bad credityou may be denied for a HELOC because lenders generally prefer a credit score at least 700, although some accept a score as low as 620.
How does a HELOC affect your credit score?
Just like with other loans, making on-time payments on your HELOC is a critical factor in the quality of your credit score.
“Paying your bills on time is the most important factor in your credit score, so a HELOC would definitely affect that,” says Ted Rossman, senior credit card industry analyst at CNET’s sister site Bankrate. “Like any loan, a late payment could significantly lower your score.”
One of the benefits of a HELOC is that it affects your credit utilization much less than a credit card would be because a HELOC is a secured loan. However, a loan secured by your home carries certain risks. When you apply for a HELOC, you are putting your house up as collateral, so if you are unable to repay your loan, your bank or lender could repossess your property to get their money back.
“Even though a HELOC is a form of revolving credit like a credit card, it’s treated differently by the credit-scoring algorithm because it’s secured by your home,” Rossman says. “So it’s treated more like an installment loan like a mortgage or a car loan.”
How is your credit score affected when you apply for a HELOC?
Once you apply for a HELOC, the lender does a serious inquiry into your credit, which will temporarily reduce your score by a few points – as with any hard draw on your credit – but shouldn’t have a major impact over a long-term period. You should, however, avoid a lot of strain on your credit in a six-month period, as this activity can cause lenders to flag you as a riskier borrower. If you need to apply for more loans, such as a car loan, try spacing out your applications six months apart. Overall, you don’t want to go over five or six hard draws on your credit over a two-year period, Rossman says.
What is the impact on your credit when using a HELOC?
Ultimately, your HELOC shouldn’t have a major impact on your credit score if you use it responsibly. In fact, a HELOC can positively affect your credit because it shows banks that you can handle various types of financial obligations over a long period of time. But if you make HELOC payments late, your credit score will drop.
“A HELOC probably won’t have a huge effect on your credit score anyway,” says Rossman. “Responsible use can slowly help you build credit over time, but late payment can be very bad (which is true for any overdue loan).”
One way a HELOC can positively impact your credit score is to use it to pay off credit card debt as it can reduce your rate of credit utilization, thereby improving your credit score.
How is your credit affected when closing a HELOC?
Closing a HELOC shouldn’t affect your credit score because HELOCs and other installment loans have minimal effect on the “how much you owe” component of your credit score, Rossman says. Paying off your HELOC will improve your debt-to-income ratio overall, but closing a HELOC shouldn’t negatively affect your credit score if you paid it off on time.
“Positive information still counts towards your credit score for up to 10 years and negative information remains for up to seven years, so there won’t be any immediate changes due to a shutdown,” Rossman said.
How to avoid the risk of negative impacts on your credit when using a HELOC
As with most loans, if you miss or make a late payment on a HELOC, it will have a negative impact your credit score because your payment history accounts for 35% of your score – a significant indicator of your creditworthiness. But because a HELOC affects your credit usage less than that of a credit card, it won’t affect your credit score the same way as when you max out your credit card.
An important way to prevent multiple difficult pull-ups from reduce your credit score is to keep multiple credit applications within a 45-day period, because FICO considers all draws within that timeframe as one draw on your credit.
If your decline in credit score for whatever reason, there are other ways to mitigate the damage to your credit score if you have an open HELOC. Focus on paying off other debts such as credit debt to increase your score. You can also open another line of credit which will lower your credit utilization ratio – but you should only do this if you can handle the additional credit liability and not take on more debt.
Are there better alternatives to a HELOC on your credit?
If a HELOC isn’t an ideal option for you and your credit score, there are other types of financing. A home equity loan, for example, is similar to a HELOC, but gives you a lump sum of cash at a fixed interest rate, which might be a smart money move in the rising interest rate environment we’re in find today. A cash-in refinance is another option, but it probably won’t make sense for homeowners who have locked in record mortgage rates over the past two years.
You can also use a personal loan Where credit card instead of a HELOC, which will likely incur higher interest rates because these are unsecured loans. But you don’t need to pledge your home to qualify for a loan. If you decide to use credit cards for financing, they can negatively impact your credit score if you miss payments.
The bottom line
As with any other loan or credit card, a HELOC can have a positive impact on your credit score if you use it responsibly. Because a HELOC is an installment loan secured by your home, it may have less of an impact on your credit score than other types of financing such as a credit card. To get the best interest rate on a HELOC, the higher your credit score, the better your chances of being approved at a lower interest rate.
