Many homeowners have more equity in their homes today than they did two years ago, thanks in large part to soaring home values during the coronavirus pandemic. For many homeowners, now is a good time to consider a home equity line of credit, or HELOC, to access funds at a lower interest rate.
Just like most loans, a HELOC can impact your credit score either positively or negatively based on how you pay it back. That’s why it’s important to make consistent, on-time payments to avoid any negative repercussions to your credit score.
Here’s what you need to know about HELOCs, how they impact your credit score, and whether it’s a good option to consider when 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 (the more mortgage payments you’ve made over the years, the more home equity you have). A HELOC is a revolving line of credit that functions like a credit card but also has a draw period (usually 10 years) that lets you continually withdraw money over time as you need it. 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.
The interest rate on a HELOC, however, 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 for a range when you plan your 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 impacts your credit utilization much less than a credit card would because a HELOC is a secured loan. 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, so if you’re unable to pay back 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,” explains Rossman. “It’s therefore treated more like an installment loan, such as 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 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.
How is your credit impacted 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 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.
How is your credit affected when closing a HELOC?
Closing a HELOC shouldn’t impact your credit score because HELOCs and other installment-type loans have a minimal effect on the “how much you owe” component of your credit score, says Rossman. 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’ve been paying it off on time.
“Positive information still counts toward your credit score for up to 10 years and negative information stays on for up to seven, so there won’t be any immediate changes due to a closure,” Rossman says.
How to avoid risks of negative impacts to your credit when using a HELOC
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.
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 alternative types of financing. A home equity loan, for example, is similar to a HELOC, but offers you one lump sum of cash upfront at a fixed interest rate, which could be a smart money move in the rising interest rate environment we’re in today. A cash-out refinance is another option, but that likely won’t make sense for those homeowners who have locked in record-low mortgage rates over the past two years.
You can also use a personal loan or credit card in lieu of a HELOC, which will likely come with higher interest rates because they’re unsecured loans. But you don’t need to put your home up as collateral to qualify for credit. If you decide to use credit cards for financing, they can have a negative impact on your credit score if you miss payments.
The bottom line
Just as with any other loan or credit card, a HELOC can impact your credit score positively if you use it responsibly. Because a HELOC is an installment loan secured by your home, it can have less of an impact on your credit score than other types of financing such as a credit card. To qualify for the best interest rate on a HELOC, the higher your credit score, the better your chances are of being approved at a lower interest rate.