How Does a Home Equity Loan Affect Your Credit?
A home equity loan impacts your FICO® Score similarly to the way other installment loans do, but a HELOC works a bit differently.
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If you own your home and have significant equity in it, you may be able to tap some of that equity through a home equity loan or home equity line of credit (HELOC). Before you do, however, it's important to consider how taking on an additional loan or line of credit may affect your FICO® Score.
Here's what you need to know about how home equity loans and HELOCs work and how they may impact your credit.
How Do Home Equity Loans and HELOCs Work?
A type of second mortgage, home equity loans and HELOCs are similar in that they both allow homeowners to access some of the equity they have in their home, either in the form of an installment loan or revolving line of credit.
With a home equity loan, you'll receive the full loan amount up front and then pay it back over a fixed period, which can be between five to 30 years, with a fixed interest rate.
In contrast, a HELOC is a revolving line of credit, similar to a credit card. Upon approval, you can take draws from your line of credit, typically via a debit card, bank transfer or even paper checks.
During the draw period, which can last up to 10 years, borrowers are only required to pay interest on the amount they've borrowed. However, if they max out their credit limit, they'll need to pay down the balance if they want to continue making draws. Once the draw period ends, they'll enter a repayment period, which can last up to 20 years, during which they'll pay down the remaining balance.
Unlike home equity loans, HELOCs typically have variable interest rates, which can fluctuate over time. In some cases, though, the lender may allow you to convert some or all of your balance to a fixed-rate payment plan.
With both types of credit, you may be able to deduct the interest you pay if you use the loan funds to buy, build or substantially improve the home used as collateral for the debt. If you use the proceeds for other purposes, though, the interest is not tax-deductible.
How Do Home Equity Loans and HELOCs Affect Your FICO® Scores?
There are several different ways that these second mortgages may impact your credit, for better or for worse. Here's a breakdown of what to expect.
Payment History
If you can manage to make your payments on time, home equity loans and HELOCs can help you increase your FICO® Scores over time.
However, if you miss a payment by 30 days or more, it could have a significant negative impact on your credit. Additionally, because you're using your home as collateral for the loan or line of credit, defaulting on your payments could result in the lender foreclosing on the home, damaging your FICO® Scores even more and leaving you without your primary residence.
As a result, it's crucial that you make sure that you can afford the additional monthly payments before you commit.
Amounts Owed
How much you owe is another important factor in your FICO® Scores. With a home equity loan and a HELOC, how much you owe is another important factor in your FICO Scores. The debt carried via a home equity loan or a HELOC can impact your FICO Scores via the “Amounts Owed” category of your credit score, under the “amount owed on all accounts” subcategory. How much of the installment loan amounts is still owed, compared with the original loan amount, may also be a factor.
Length of Credit History
Adding a new tradeline to your credit reports will result in the average age of your accounts going down, which could have a negative impact on your FICO® Score. However, because home equity loans and HELOCs often have long terms, they can have a positive impact on your credit over time, particularly if you manage them responsibly.
New Credit
Each time you apply for credit, the lender will typically run a hard inquiry on your credit reports to evaluate your creditworthiness. A new inquiry may knock fewer than five points off your FICO® Score, but if you apply for multiple credit accounts it could have a compounding effect. Keep in mind, though, that inquiries (and other changes to your credit report) impact everyone's scores differently, depending on their credit history. Some people might see bigger changes than others.
The good news is that if you want to shop around and compare interest rates and terms before deciding on a lender, you can usually do so without worrying about damaging your credit score too much. With newer FICO® Score models, mortgage, auto and student loan hard inquiries made within a 45-day rate-shopping period are combined into one for scoring purposes.
Credit Mix
Having different types of credit can help boost your FICO® Scores because it shows that you can manage a range of credit options. So, adding a second mortgage could potentially improve the credit mix component of your credit scores.
Make Sure Your Credit Is Ready for a Home Equity Loan or HELOC
If you're thinking about applying for a home equity loan or HELOC, it's important to understand the requirements and to prepare your credit for the application process.
Like conventional mortgage loans, second mortgage loans typically require a FICO® Score of 620 or above, though some lenders may provide some flexibility. Regardless, the higher your FICO Score, the better your chances of securing a lower interest rate.
Additionally, many lenders only allow you to borrow up to a combined loan-to-value ratio (CLTV) of 80%, which means that the balances on both your primary and second mortgages cannot exceed 80% of the value of your home. But again, some lenders may be more flexible than others, and you may be able to borrow up to a CLTV of 100%.
In addition to your credit history and home value, lenders will also consider your debt-to-income ratio (DTI), which is the percentage of your gross monthly income that goes toward debt payments. DTI requirements can vary by lender, but you can generally expect a limit of 43%.
Before you apply for a home equity loan or HELOC, check your FICO® Scores and review your credit reports to determine if you need to make improvements first. Then, calculate your DTI and how much equity you have in your home to determine your approval odds.
If you have any questions about eligibility, consider reaching out to individual lenders to learn more.
Whatever you do, it's critical that you take the time to consider whether a home equity loan or HELOC is financially feasible for you and whether you can use the debt to improve your financial situation and credit history over time.
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Ben Luthi has been writing about money and travel for seven years. He specializes in consumer credit and has written for several major publications and industry leaders, including U.S. News and World Report, Fox Business, Wirecutter, Experian, and Credit Karma.