A home equity loan may lower credit scores and make credit more expensive in other areas, such as buying a car – but the HELOC impact may also be minimal.
SAN JOSE, Calif. – Homeowners with significant equity may be able to tap some of that through a home equity loan or home equity line of credit (HELOC). Before they do, however, it’s important to consider how taking on an additional loan or line of credit may affect their credit score.
According to the myFICO blog, home equity loans and HELOCs 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, they receive the full loan amount upfront and pay it back over a fixed period – often five to 30 years – with a fixed interest rate.
A HELOC is a revolving line of credit, similar to a credit card. Upon approval, they can draw from their home-equity line of credit, typically via a debit card, bank transfer or even paper check. 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 enter a repayment period, which can last up to 20 years, during which they’ll pay down the remaining balance. During the draw period, a homeowner can spend their home equity and repay it as their needs change.
Unlike home equity loans, HELOCs typically have variable interest rates, which can fluctuate over time. In some cases, though, the lender may allow them to convert some or all of the balance to a fixed-rate payment plan.
With both types of credit, homeowners may be able to deduct the interest they pay, providing they use the loan funds to buy, build or substantially improve the home used as collateral for the debt. If they use the proceeds for other purposes, though, the interest isn’t tax-deductible. Owners should contact their tax professional for more advice on this, however.
Do home equity loans and HELOCs affect FICO scores?
There are several different ways that second mortgages may impact credit, for better or for worse. Here’s a breakdown:
Payment history: If equity borrowers make payments on time, home equity loans and HELOCs can help them increase their FICO Scores over time. However, if they miss a payment by 30 days or more, it could have a significant negative impact on their credit.
In addition, they’re using their home as collateral. As a result, defaulting on payments could lead to foreclosure. That not only has a major impact on their credit score, they also lose their primary residence.
Amounts owed: How much a borrower owes also impacts their credit score. The debt carried via a home equity loan or HELOC can impact FICO Scores via the “Amounts Owed” category of their score, under the “amount owed on all accounts” subcategory.
How much of the installment loan amounts still owed compared with the original loan amount may also be a factor.
Length of credit history: Adding a new tradeline (the home equity loan) to credit reports will result in the average age of all credit accounts going down. And that could have a negative impact on a FICO Score.
However, home equity loans and HELOCs often have long terms, so they can have a positive impact on credit scores over time, particularly if they’re managed responsibly.
New credit: Each time a consumer applies for credit, a lender will typically run a hard inquiry on their credit reports to evaluate creditworthiness. A new inquiry may knock fewer than five points off a FICO Score, but if they apply for multiple credit accounts it could have a compounding effect.
Inquiries and other changes to a credit report impact everyone’s scores differently, however, depending on their credit history. Some people see bigger changes than others.
The good news: If consumers want to shop around and compare interest rates and terms before deciding on a lender, they can usually do so without worrying about damaging their 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.
Credit mix: Having different types of credit can help boost FICO Scores because it shows that the borrower can manage a range of credit options. Adding a second mortgage could potentially improve the credit mix component.
Check credit scores before applying for home equity
If thinking about applying for a home equity loan or HELOC, it’s important to understand the requirements. Like conventional mortgage loans, second mortgage loans typically require a FICO Score of 620 or above, though some lenders may provide flexibility. Regardless, the higher a FICO Score, the better the chances of securing a lower interest rate.
Additionally, many lenders only allow homeowners to borrow up to a combined loan-to-value ratio (CLTV) of 80%, which means the balances on both their primary and second mortgages can’t exceed 80% of their home’s current value. But again, some lenders may be more flexible with some even going as high as 100%.
In addition to credit history and home value, lenders will also consider debt-to-income ratios (DTI) – the percentage of a homeowner’s gross monthly income that goes toward debt payments. DTI requirements vary by lender, but generally expect a limit of 43%.
Before applying for a home equity loan or HELOC, check FICO® Scores and review credit reports to determine if improvements should be made first. Then, calculate DTI and how much equity is in the home to determine the odds of approval.
Questions? Reach out to individual lenders to learn more.
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