Most homeowners know they can access credit with a lower interest rate than a standard credit card through a HELOC secured by home equity. Yet many people don’t always realize the potential credit score impact from this new line of revolving credit.
So, how does a HELOC affect your credit?
How much you borrow, your payment terms, and how it fits into the total puzzle of your available credit are all important factors. Read on for help deciding whether a HELOC is right for your needs and how to use it to boost your credit score.
What Is a HELOC?
A home equity line of credit, or HELOC, is a variable-rate revolving line of credit secured by your property.
So how does a HELOC work? A HELOC loan typically starts with a draw period of five to 10 years when you can take out funds and make interest-only payments, and ends with a repayment period of 10 to 20 years. You no longer have access to borrow funds during the repayment period, and your monthly payment jumps to include principal plus interest.
The Impact of a HELOC on Your Credit Score
There are three main ways a HELOC will affect your credit score. These are:
- The credit inquiry during the application process
- How the HELOC fits into your total credit utilization
- How you use and repay your HELOC
The Effect of Applying for a HELOC on Your Credit Score
The act of applying for a loan or credit line—whether your application is accepted or rejected—typically involves a hard pull, which lowers your credit score. For example, even if you have a denied HELOC application, your credit score will still be lowered.
On average, hard pulls (also called “hard credit inquiries”) cause a drop of five to ten points that lasts for one year, and the inquiry remains visible on your credit history for two years. There will be a smaller effect if you have good credit history and haven’t had multiple credit inquiries on your account.
Learn more about how to qualify for a HELOC to ensure your application is accepted.
The Influence of a HELOC on Your Credit Utilization Ratio
A credit utilization ratio reflects how much of your available revolving credit you’re using at a given time. To calculate it:
- Total your credit by adding up the credit limits on all of your credit lines and cards
- Total your debt by adding up the balances on all of those credit lines and cards
- Divide debt by credit and multiply the number by 100 to express it as a percentage
For example, if Kaitlyn has a Visa with a $10,000 limit, a MasterCard with an $8,000 limit, and a HELOC for $65,000, her credit totals $83,000. She owes $6,000 on her Visa, $4,500 on her MasterCard, and has drawn $10,000 from her HELOC, for a debt total of $20,500. Her credit utilization ratio is 25%:
(6,000 + 4,500 + 10,000) ÷ (10,000 + 8,000 + 65,000) = 0.25
0.25 x 100 = 25%
Credit utilization is one of the highest contributing factors to credit scores, second only to payment history. Experts recommend using 30% or less as a goal, or a single digit if you’re aiming for the coveted 850—people with perfect credit scores have an average ratio of 6%.
How Using a HELOC Affects Your Credit Score
HELOCs come with the potential to help or hurt your score.
Your HELOC loan can improve your credit by:
- Building your overall credit history over time
- Creating a positive payment history by making consistent, timely payments
- Diversifying your mix of loan and credit types
- Paying off higher-interest credit card debt
- Improving your credit utilization ratio by paying the balance monthly or keeping it low
On the other hand, avoid damage from:
- Late payments
- A high balance due—try to make principal payments during the draw period
- Using HELOC proceeds to fund living expenses vs. critical needs or investments
- Applying with multiple lenders—shop around first, before submitting an application
- Refinancing your HELOC multiple times
The Impact of Closing a HELOC on Your Credit Score
Remember Kaitlyn from above? Once she closes her HELOC, she’s removing that $65,000 from her available credit, which significantly increases her credit utilization ratio. Using the same numbers for her credit card debt, her ratio (previously 25%) is now at 58%:
(6,000 + 4,500) ÷ (10,000 + 8,000) = 0.58
0.58 x 100 = 58%
Closing a HELOC after it’s paid off bumps up your credit utilization ratio, sometimes enough to make it difficult to qualify for further credit or loans if you have high balances on other open accounts.
Comparing HELOCs with Other Financial Options
Before you decide on a HELOC lender, consider “Is a HELOC a good idea for me?” Depending on your goals, timeline, and financial picture, you may want to consider a:
- Home equity loan
- Cash-out refinance
- Personal loan secured by other assets
- Low-APR credit card with a balance transfer or other useful offer
- Sale-leaseback program—a debt-free alternative
HELOCs can improve credit scores by contributing to your credit mix and longevity, payment history, and credit utilization ratio.
HELOCs can damage credit scores through the credit check during application, missed or untimely payments, default on repayment, over-use of the credit, and a consistently high balance due. Your credit score could also take a hit from closing the HELOC, which reduces your available credit and increases your credit utilization ratio.
Consider alternatives including equity-based debt and non-equity credit, or avoid debt entirely with a sale-leaseback.
- WalletHub. How many points does a hard inquiry affect a credit score? https://wallethub.com/answers/cs/how-many-points-does-a-hard-inquiry-affect-credit-score-2140706774/
- Bankrate. Everything you need to know about credit utilization ratio. https://www.bankrate.com/finance/credit-cards/credit-utilization-ratio/