Homeowners looking to do a home remodel, help pay for college costs or pay down debt may consider using the equity they've built in their home to get a home equity line of credit (HELOC). While a HELOC can be a big help when you need to borrow money, it also puts your house at risk in the event you have difficulty paying back the loan.
A HELOC can also affect your credit score—positively or negatively—depending on how you manage the account. Your score could benefit if you make timely payments and keep the amount you borrow from your HELOC relatively low, but falling behind on your payments could mean bad news for your credit score and overall financial health.
What Is a HELOC?
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 similar 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.
HELOCs and Your Credit
The impact a HELOC has on your credit score depends on how you use the funds and manage the account. You can help your score by making on-time payments on your HELOC. Like with any credit account, however, if you're late on a payment your score will suffer.
If you're using a lot of the available credit on your credit cards, you likely have a high credit utilization ratio that is hurting your score. Using your HELOC to pay off those credit card balances—as long as you keep the balances at zero going forward—will lower your utilization and can give your scores a boost.
One common misconception about HELOCs is that the balance figures into your credit utilization ratio. But because a HELOC differs from other credit lines in that it is secured by your home, FICO® (the credit score used most often by lenders) is designed to exclude HELOCs from revolving credit utilization calculations.
Another thing to keep in mind: Your lender will perform a hard credit inquiry when you apply for a HELOC. Your score may drop by a few points (if at all), but the impact diminishes over time.
Pros and Cons of HELOCs
There are a few key benefits to getting a HELOC:
- Lower interest rates: HELOCs generally have lower interest rates than credit cards and unsecured loan products because they are secured by your home. This means your home is used as collateral and protects the lender if you default on the loan.
- Access to large amounts: You may not have a lot of luck borrowing large amounts of cash if you apply for a credit card or personal loan. However, a HELOC gives you a better shot at getting approved if you have a large sum of equity in your home and meet the lenders' other qualification criteria.
- Flexible: You can draw as much as little as you need, up to the amount of available credit with a HELOC. This means you will only be responsible for interest on the funds you actually use. Installment loans don't give you this luxury: You have to pay interest on the total amount you borrow. For example, if you get a $80,000 HELOC and only use $20,000, you will only make payments on the $20,000 plus interest. But if you get a loan for $80,000, interest will be assessed on the entire amount.
There are some significant drawbacks to consider, however:
- Lower equity in your home: HELOCs reduce the amount of equity in your home. This could be problematic if your home value drops substantially and you decide to or need to sell it.
- Higher payments: Once your draw period ends, you'll begin making payments on the principal—which will be much higher than the interest-only payments you'd made up to that point. If you can't make the new monthly payments, you could lose your home.
- Putting your home at risk: If you're not sure you'll be able to make the payments on your loan—and thus hold on to your home—a HELOC is probably not a good choice.
The Bottom Line
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.