Homeowners who want to improve their homes, pay for college, or pay off debt may want to consider obtaining a home equity line of credit (HELOC). While a HELOC might be beneficial when borrowing money, it also puts your home at danger if you are unable to repay the debt.
A HELOC can also affect your credit score, either positively or badly, depending on how you manage the account. If you make timely payments and keep the amount you borrow from your HELOC relatively low, your score may improve; nevertheless, falling behind on your payments may have a negative impact on your credit score and your financial health.
A HELOC is a revolving line of credit that allows you to borrow against the equity in your home. The amount you can borrow is determined by the assessed value of your home, minus the remaining balance on your mortgage. And you can use the funds as you see fit.
Most lenders cap HELOCs at 60% to 85% of the home’s value. They will also evaluate other factors, including your creditworthiness, to determine the line of credit. To illustrate, if your home is currently worth $420,000 and the outstanding balance on your mortgage is $150,000, you have $270,000 in home equity. In this case, the lender may offer you a HELOC of up to $229,500, assuming you meet other qualifying criteria.
HELOCs operate similarly to credit cards: You can borrow as much as you need up to your limit. Unlike credit cards, HELOCs have a set “draw period,” typically 10 years, during which you can access funds. During that time you’ll make interest-only monthly payments on what you borrow, though you can usually add extra principal to your payments. When the draw period ends, the lender will generally spread the principal payments over 20 years, or you can refinance the loan.
HELOCs are not the same as home equity loans, however. While a home equity loan is also based on the equity you’ve built in your home, it is an installment loan rather than a revolving line of credit. This means the lender disburses all the funds at once, and you must repay them over the loan term. Home equity loans also typically have a fixed interest rate, but the rate on HELOCs are usually variable.
Does a HELOC Affect Your Credit Score?
A HELOC is a revolving loan that allows you to access the equity in your home to pay for large purchases or consolidate consumer debt. A HELOC uses your home as collateral, so the interest rates on a HELOC are typically lower than rates on unsecured loans, such as credit cards and personal loans.
To determine how much you may be able to borrow, a lender gauges the appraised value of your home minus what you still owe on your mortgage — your equity, in other words. Most lenders allow you to borrow a certain percentage of the equity in your home, so the more equity you have, the more you may be able to borrow.
Unlike a home equity loan, which you receive as a lump sum, you only have to pay back what you actually spend from a HELOC. And as you pay back the balance, you can continue to draw additional amounts from your HELOC over time, as long as you don’t go over your credit limit.
HELOC loan terms set up two periods: the draw period and the repayment period.
During the draw period, you can spend up to your credit limit whenever you like. Typically, you access the funds from a HELOC with a credit card or special checks that are linked to the account. It’s important to note that some lenders require you to withdraw a minimum amount for every transaction or keep a minimum balance on the account.
Once the borrowing period is over, you enter the repayment period. Whether you were making interest-only payments, partial payments or no payments at all during the borrowing period, your lender will have specific requirements when it comes to repaying the full line of credit.
Read Also: HELOC Strategies: Paying Off Debt vs Investing in Your Home
Some lenders will give you several years to repay the loan in monthly installments, while others may require that you repay the credit amount in full. This is known as a balloon payment. Ensure you are well aware of your lender’s repayment requirements when you open a HELOC. If you can’t make the payments, you risk losing your house to the lender.
Benefits of Using a HELOC
When deciding whether or not a HELOC is right for you, consider the following benefits of a HELOC:
- Once you apply and are approved, the credit is there and can be used as an emergency fund. You don’t have to draw from a HELOC, but you can if you need to.
- During the borrowing period, you may be able to make interest-only payments, which means the initial payments will be low.
- A HELOC may entitle you to certain tax benefits.
- You don’t have to pay back the entire amount you qualify for, just the amount you spend.
- You may continue to draw from the credit line as much or as little as needed during the borrowing period without any extra approvals or paperwork.
- The average HELOC interest rate is generally below that of a credit card.
HELOCs can be used for the following:
- Paying off high-interest credit cards with lower-interest debt
- Establishing an emergency fund
- Paying for home repairs or making home improvements
Whatever you choose to do with your money, it’s smart to make a plan and stick to it. It can be tempting to spend your entire credit limit, but if you can’t pay back the principal plus interest, you may find yourself in a tough spot when the payments come due.
Does a HELOC Affect Your Credit Score?
A HELOC may affect your credit score, but not the way you might think. Keep in mind that credit scores include seven different pieces of information:
- Bill-paying history
- Current unpaid debt
- The type and number of loans you have
- History of loan accounts
- Percentage of credit limit you are using
- How often you apply for new credit
- Whether and when you have ever had a debt sent to collections, had a foreclosure or declared bankruptcy
A HELOC in your name impacts these factors, but how you use that credit is what affects your credit score. Making on-time payments is one factor that may positively impact your credit score, while late or missed payments can negatively affect your credit score.
HELOCS are considered a revolving type of credit like credit cards, but they don’t impact your credit score the same way. Remember that credit utilization is a factor in your credit score. Experts suggest using no more than 30% of your available credit limit to boost your credit score. However, the FICO credit-scoring model excludes HELOCs from the 30% credit utilization ratio, in part because the credit line is secured by the borrower’s home.
Another factor to consider is how many “hard pulls” on your credit are made when choosing the right HELOC (or any loan) in a six-month period. If you receive multiple quotes from different lenders that all require a hard pull on your credit history, this may negatively impact your credit score. While shopping around, try to consolidate your inquiries to a 15-day to 45-day window, as credit bureaus consider similar inquiries made in a short period of time as one pull on your credit.
In short, simply having a HELOC doesn’t necessarily mean you will improve or harm your credit score. There are things you can do to lessen the impact on your credit score when you take out a HELOC.
Credit scores are multipoint numbers that are influenced by multiple factors. Simply having one type of loan over another doesn’t mean your credit will be good or bad. Rather, your credit score depends on the length of your debt history, the timeliness of your payments and the variety of debt you hold.
If you’ve ever paid off a car loan and then saw your credit score go down, you might have wondered why. This is because you no longer have that specific type of debt influencing your credit score. Thus, a HELOC can add variety to your credit history while also carrying the weight of a mortgage-related loan, which is viewed as more dependable by credit bureaus because it’s attached to collateral.
Another factor to consider is whether you pay your HELOC payments on time every month. This shows credit bureaus you are reliable and may, in turn, improve your credit score. But if you miss payments or make late payments, not only might this negatively impact your credit score, but you’ll also be at risk of losing your home.
There are a few steps you can take to obtain a HELOC with minimal impact on your credit:
- Start by checking your credit score to understand how a lender might view your application. If your credit score is low, consider working to improve your score before applying for a HELOC.
- Evaluate your home equity with a qualified appraiser to determine how much you may be able to borrow.
- Shop different lenders and compare rates and terms to help ensure you are getting the best deal for your situation.
- Keep any credit applications within a 14- to 45-day period to aid in making sure the inquiries are seen as only one credit pull.
- Remember that a hard pull on your credit may only result in a minimal and temporary drop in your credit score. If these steps are followed with on-time payments and a healthy credit history, your credit score will likely return to its original state.
If you follow these steps, you can stay in control of your credit by making measured choices that work best for your situation. And don’t be afraid to take step No. 2 seriously — this is a key part of getting the best rate. Make sure you’re carefully considering all your options before making a long-term decision that can provide you with greater cash flow, but also one that may have dire consequences if you don’t follow the payment plan.
What are the Pros and Cons of a HELOC?
Pros
- Lower interest rates
While home-loan interest rates overall have risen dramatically since 2022, HELOC rates still tend to be lower than those on credit cards and personal loans. If you qualify for the best rates, a HELOC can be a less expensive way to consolidate debt or finance a home renovation.
- Flexibility
With a HELOC, you use the funds as you need them, then repay only what you borrowed (with interest). If you wind up needing less cash than you thought, you’ll have smaller repayments, too. In contrast, home equity loans and personal loans offer a lump sum that has to be repaid in full (also with interest), whether you use all of the money or not.
Most home equity lenders also offer flexibility in terms of how you access your HELOC funds, such as debit cards, checks, ATMs and online transfer. In addition, some allow you to convert all or a portion of your HELOC balance to a fixed rate, so you won’t risk getting hit with higher interest later on.
Another point of flexibility: is repayment. Many lenders also offer an interest-only HELOC, with which you only pay interest — no principal — during the draw period (typically 10 years). Doing so helps keep your payments manageable. Of course, you can always opt to pay back the principal, all or in part, which in turn elevates your credit line.
- Possible tax deduction
Even after the Tax Cuts and Jobs Act of 2017, you can still deduct interest paid on a HELOC if you use the money for home renovations. Specifically, the IRS allows deductions on the interest if the HELOC funds are used to “buy, build or substantially improve the residence.” You can only take the deduction up to a certain threshold, however, based on your total mortgage debt. You must also itemize deductions to take advantage of this write-off.
- Potential boost to credit
Two of the most important components of your credit score are your payment history and credit mix. Adding a HELOC to your history and paying it on time can help boost your score. (However, keep in mind that changing your credit utilization ratio by taking on the HELOC could actually make your score go down, too.)
- High loan limits
HELOCs are intended for large amounts — at least five figures. Frequently, $10,000 is the minimum credit line you can establish. The benchmark HELOC whose rate Bankrate tracks is for $30,000. Many lenders offer credit lines as high as $500,000 or $750,000.
How big your line of credit is, however, depends on the equity in your home — that is, how much of it you own outright. Generally, you can borrow up to 80 percent of your equity stake — sometimes as much as 90 percent, depending on the lender and your financials. However, your outstanding mortgage also impacts the amount of equity you can tap. When they say you can borrow up to 80 percent, they mean the sum total of all your home-based debt (current mortgage plus new HELOC) can’t exceed 80 percent of your home’s value. In financial-speak, this is called your combined loan-to-value ratio (CLTV).
For example: Assume your home is worth $425,000 and your outstanding mortgage balance is $250,000. This means you have $175,000 in equity and a loan-to-value (LTV) ratio of 59 percent ($250,000 / $425,000 * 100). Your lender lets you borrow up to 80 percent of your equity. That means if the lender approves you for a HELOC, your maximum credit line is $90,000 ($425,000 *.80 – $250,000).
Cons
- Rates are variable
While home equity loans come with a fixed interest rate, HELOCs have variable rates. This means that your rate can go up or down based on economic conditions, the Fed’s monetary policy and other factors, which in turn affects your payments. Even if you take out a HELOC at a lower rate, you could face much higher interest rates when it comes time to repay.
- House is on the line
A HELOC is a secured loan, meaning you put your home up as collateral. While secured loans tend to have lower rates, you’re taking on some additional risk by putting your house on the line. “Because you are borrowing against your home, if you can’t make your monthly payments, you risk foreclosure,” says Sean Murphy, assistant vice president of mortgage operations, closing at Navy Federal Credit Union.
- Reduced equity cushion
When you borrow through a HELOC, you’re borrowing against your home’s equity. If home prices drop, you could wind up owing more than your home is worth. In addition, if your home is your largest asset, tying up your equity with a HELOC might limit additional opportunities to borrow, as well as the ability to leverage your equity in an emergency.
- Potential to run up balance quickly
Because many HELOCs allow interest-only payments during the draw period, it’s easy to access cash without considering the financial ramifications. “If the borrower is not returning funds to this line of credit, then the loan eventually begins to amortize and the payments go up significantly,” says Joseph Polakovic, owner and CEO of Castle West Financial in San Diego. Bottom line: An unwelcome surprise can await you when the repayment period starts if you haven’t expected/budgeted for a jump in your monthly payments.
Final Thoughts
A HELOC can be a viable solution to a cash need in certain situations. Still, it’s essential to understand how it works and whether it’s risking your home. You should also understand how HELOC could affect your credit before you apply. Depending on credit rating and financial situation, there may be better options out there.
Check your credit score to see where you stand when exploring borrowing options. It may be better to hold off on applying and work to improve your score to ensure you get the most competitive terms when you’re ready to move forward. You can check your Experian credit report and FICO® Score☉ for free to find out where you stand.
