These days, it may be more difficult to afford monthly payments for products such as home equity lines of credit (HELOCs). If you are not attentive, this may have an influence on your credit score.

The cost of borrowing money has grown considerably in the last year. To combat inflation, the Federal Reserve has raised its benchmark interest rate several times, most recently by 25 basis points (0.25%) at its March meeting. These increases directly affect interest rates for home equity products such as HELOCs.

A HELOC, like most loans, can have a favorable or negative impact on your credit score depending on how you back it. That is why it is critical to make consistent, on-time payments to avoid any bad consequences for your credit score.

Here’s everything you need to know about HELOCs, how they effect your credit score, and if they’re a viable alternative for accessing home equity.

What is a HELOC?

A HELOC is a loan that lets you borrow against the equity you’ve built up in your home over an extended period of time. Your equity — how much of your house you own — is determined by the current value of your home as well as how much of your mortgage is paid off. It’s important to note that HELOCs are secured by a collateral — your home. If you default on payments for any reason, you could lose your home. 

When you borrow with a HELOC, you have a revolving line of credit (much like a credit card) that you can tap as needed over the course of the draw period (usually 10 years). One benefit of a HELOC is that you can make interest-only payments during your draw period, which means you can borrow a large sum of money over a long time period while only making minimum monthly payments. When the draw period ends, you’ll be responsible for making payments towards both the principal and the interest, resulting in significantly higher monthly payments. 

The interest rate on a HELOC is variable, which means your monthly payments can fluctuate based on what’s happening with interest rate trends and the economy. If you’re considering a HELOC, be sure you budget accordingly to ensure you can comfortably afford a range of monthly payments.

What is a Credit Score?

A credit score is a three-digit number that lenders use to evaluate how likely you are to pay back a loan. The higher the number, the better the score. The FICO score, one of the major credit scoring models, ranges from 300 to 850 and is divided into five tiers from very poor (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 one important factor is your payment history, which comprises 35% of your credit score. To qualify for excellent credit, you must make loan payments consistently and on time to prove that you are responsible and reliable to pay back the loan on time. If you make late payments, your credit score will decrease and lenders will regard you as a credit risk, penalizing you with less favorable loan terms including a higher interest rate.

Credit agencies collect such information as your payment history, your credit utilization (or how much of your available credit you’ve used), the length of your credit history and the types of loans and credit cards you have outstanding. All of that information helps determine your FICO score. If you have poor credit, you may be declined for a HELOC because lenders typically prefer a credit score of at least 700, although some will accept a score as low as 620.

How Does a HELOC Affect Your Credit Score?

Just like with other loans, making on-time payments to 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 certainly affect that,” says Ted Rossman, credit card senior industry analyst at Bankrate, CNET’s sister site. “Like any loan, a late payment could significantly drag down your score.” 

One benefit of a HELOC is that it doesn’t factor quite as much into your credit utilization the way a credit card does. This is because a HELOC is a secured loan.

“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,” explains Rossman. “It’s therefore treated more like an installment loan, such as a mortgage or a car loan.” 

Read Also: HELOC Rates and the Real Estate Market: What’s the Connection

Nevertheless, a loan secured by your home comes with some risk. When you apply for a HELOC, you’re putting your home up as collateral. If you’re unable to pay back your loan, your bank or lender could repossess your property to get their money back.

Once you apply for a HELOC, the lender makes a hard inquiry on your credit, which will temporarily drop your score by a few points — just as with any hard pull on your credit — but it shouldn’t have a major impact over a long-term period.

You should, however, avoid numerous hard pulls on your credit within a six-month period, as that 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 to space out your applications by six months. Overall, you don’t want to exceed five or six hard pulls on your credit in a two-year span, says Rossman.

Ultimately, your HELOC shouldn’t have a major impact on your credit score if you use it responsibly. In fact, a HELOC can affect your credit positively because it shows banks that you can handle various types of financial obligations over a long period of time. But if you make late HELOC payments, your credit score will drop. 

“A HELOC probably won’t have a huge effect on your credit score either way,” says Rossman. “Responsible use can slowly help you build credit over time, but a late payment can be very bad (which is true of paying any loan late).”

One way a HELOC can positively impact your credit score is by using it to pay off credit card debt because it can lower your credit utilization ratio, thereby improving your credit score.

Just as with most loans, if you miss or make a late payment on a HELOC, it will negatively impact your credit score as your payment history makes up 35% of your score — a significant indicator of your creditworthiness. But because a HELOC affects your credit utilization less than that of a credit card, it won’t ding your credit score the same way as it would when you max out on a credit card. 

An important way to prevent multiple hard pulls from lowering your credit score is to keep multiple credit inquiries within a 45-day period, as FICO considers all pulls within that timeframe as one single pull on your credit. 

If your credit score drops for any reason, there are other ways to mitigate damage to your credit score if you have an open HELOC. Focus on paying down other debts such as credit debt to raise your score. You can also open another line of credit which will lower your credit utilization ratio — but you should do that only if you can manage the extra credit responsibility and not get further into debt. 

What Influences HELOC Rates?

If you need a flexible means to borrow money over time, such as for a home remodeling project, you might look into a home equity line of credit or HELOC. These are designed so that you can borrow money for a fixed “draw period,” which typically lasts roughly ten years. Following that, it transitions to a “repayment period,” during which you reimburse the balance of the money borrowed.

Many people prefer these loans over credit cards for one major reason: The interest rates are generally a lot lower because they’re tied to the equity you have built up in your home. Although this means you could lose your home if you don’t repay the loan, if you don’t anticipate having repayment problems, it’s a more affordable way to borrow flexible funds.

How much your HELOC will actually cost in terms of interest rates depends on several factors. If you know them, you can find ways to obtain cheaper rates on your HELOC.

Some factors aren’t within your control when it comes to what interest rate lenders offer you on a HELOC. They generally are related to broader economic conditions, which cause the baseline for what lenders charge to rise or decline. This baseline is known as the prime rate, and it’s the rate lenders offer the highest-qualified customers.

Banks set their prime rates based on the federal funds rate, which is how much it costs them to borrow short-term overnight loans to ensure they have the required amount of cash reserves on hand in case there’s a run on the bank, as happened during the Great Depression.

The federal funds rate, in turn, is set by the Federal Reserve. It does so as part of a broader policy aimed at influencing big economic trends, such as keeping inflation low or spurring economic growth, when needed. That’s why, in 2022, the Fed has been increasing the federal funds rate to try to spur banks to charge higher interest rates to put a brake on increasing inflation.

Your lender’s prime rate will set the baseline for what it could charge you as an interest rate on a HELOC. But from that baseline, the lender could adjust your rate higher, based on how risky it perceives you to be. Here are the different factors lenders consider.

Credit Score

The biggest factor influencing your interest rate for just about any loan—including a HELOC—is your credit score. The higher your credit score, the lower the interest rate you’ll have to pay.

Each lender sets its own requirements for the credit scores that qualify for particular rates. But in general, if your credit score is 740 or higher (considered to be very good to excellent credit, according to credit-scoring calculation company FICO), you’re more likely to qualify for the best HELOC interest rates.

Debt-to-Income Ratio

Having too much debt can also make you look risky in the eyes of a lender because it might mean you may have trouble affording an added HELOC payment. When it comes to this factor, there are no standardized rules about what percentage of your income should go toward debt payments (also known as your debt-to-income ratio, or DTI).

Again, each lender may set their own rules. But a good number to keep in mind is a 43% debt-to-income ratio because that’s the maximum you can generally have to get a mortgage. If your DTI ratio is above this level, you might have problems qualifying for a HELOC or other loans.

If your DTI ratio is a little high, try paying off debt using the debt snowball method or increasing your income. Both of these will lower your debt-to-income ratio to more reasonable levels, and you’ll have an easier time making your payments, too.

Amount of Home Equity

Some lenders charge higher rates if you don’t have enough equity built up in your home yet. This also relates to your debt level because the more mortgage debt you have (in other words, less home equity), the more of a risk you run of defaulting on your HELOC.

If you don’t have at least 15% to 20% equity in your home, it might be time to focus on paying down your mortgage first or pursuing another option.

How To Get the Best HELOC Interest Rates

HELOCs are one of the more confusing, but often worthwhile, types of ways you can borrow money. As such, it’s especially important that you shop around to make sure you’re getting the best rates and that you fully understand how the HELOC works. You can do this by keeping the following actions in mind:

• Check your credit reports: It’s not uncommon for credit reports to have errors that can affect interest rates. So before you start shopping, check your credit reports to make sure they’re accurate and that you’re not unfairly penalized.
• Keep track of your estimates: You’ll need to compare a lot of details to find the best HELOC for you. A HELOC pamphlet from the Consumer Financial Protection Bureau (CFPB) has a great fill-in worksheet you can use to compare the quotes received.
• Contact as many lenders as possible: By reaching out to more lenders to ask for a quote, you increase your odds of finding the best option for you. Check with banks, credit unions, and online lenders to make sure you’re covering all bases.
• Get your rate shopping done fast: Each time a lender does a hard credit check, it could ding your credit score slightly. But if you get all your rate-shopping done in a two-week period, they will be bundled and recorded as a single inquiry, which will help preserve your credit score.

Home equity interest rates vary widely by lender and the type of product. Generally speaking, home equity lines of credit (HELOCs) have lower starting interest rates than home equity loans, although the rates are variable. Home equity loans have fixed interest rates, which means the rate you receive will be the rate you pay for the entirety of the loan term.

As of April 24, 2024, the current average home equity loan interest rate is 8.63 percent. The current average HELOC interest rate is 9.10 percent.

To combat inflation, the Fed raised the federal funds rate 11 times from early 2022 through mid-2023, driving a sharp rise in home equity products’ rates too — especially HELOCs, which doubled from 4.2 percent in January 2022 to 8.65 percent in July 2023. In November 2023, they topped 10 percent, the highest rate in 20 years.

But, at its last five meetings, including the latest on Mar. 20, the central bank has kept interest rates unchanged, and those of home equity products have calmed as well. But they remain elevated: The average home equity loan and HELOC now hover just under 9 percent — a reflection of fears that the Fed could resume its hikes if inflation’s pace doesn’t subside.

A good rate on any type of loan is generally considered to be a rate lower than the national average. The rates that lenders display on their websites are typically the best rate they offer, and they often reserve them for borrowers with higher credit scores and a lower loan-to-value (LTV) ratio. For home equity products, some lenders also reserve their best rates for borrowers willing to set up automatic payments or withdrawals.