SAN JOSE, California–(BUSINESS WIRE)–If you own your home and have significant equity, you may be able to tap into some of that equity through a home equity loan or home equity line of credit (HELOC). Before you do so, however, it’s important to consider how taking out 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 can affect your credit, from myFICO.
For more information on loans and credit, visit the myFICO blog at https://www.myfico.com/credit-education/blog
How do home equity loans and HELOCs work?
A type of second mortgage, home equity loans, and HELOCs are similar in that they allow homeowners to access a portion of the equity they have in their home, either in the form of an installment loan or a revolving line of credit.
With a home equity loan, you receive the full loan amount up front and then pay it back at a fixed rate over a set period of time, which can range from five to 30 years.
In contrast, a HELOC is a revolving line of credit, similar to a credit card. Once approved, you can make withdrawals from your line of credit, typically via a debit card, wire transfer, or even paper checks.
During the drawing period, which can last up to 10 years, borrowers only have to pay interest on the amount borrowed. However, if they have exhausted their credit limit, they will have to pay back the balance if they wish to continue drawing. After the drawing period ends, they enter a payback period that can last up to 20 years, during which they pay back the balance.
Unlike home equity loans, HELOCs typically have variable interest rates that can fluctuate over time. However, in some cases, the lender may allow you to convert some or all of your balance to a fixed-rate payment plan.
With either type of loan, you may be able to deduct the interest you pay when you use the loan funds to buy, build, or substantially improve the home that serves as collateral for the debt. However, if you use the proceeds for other purposes, the interest is not tax deductible.
How do home equity loans and HELOCs affect your FICO® scores?
There are several ways these second mortgages can affect your credit score, for better or for worse. Here’s a breakdown of what to expect.
If you 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 can have a significant negative impact on your credit score. Additionally, since you’re using your home as collateral for the loan or line of credit, defaulting on payment can result in the lender foreclosure of the home, further damaging your FICO® scores and leaving you without your primary residence.
Therefore, it’s important to make sure you can afford the additional monthly payments before committing.
How much you owe is another important factor in your FICO® scores. With a home equity loan and HELOC, the amount of debt you owe is another important factor in your FICO scores. Debt borne through a home loan or HELOC can affect 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 amount is still owed compared to the original loan amount can also play a role.
Credit history length
Adding a new tradeline to your credit reports will cause the average age of your accounts to decrease, which could negatively impact your FICO® score. However, because mortgage loans and HELOCs often have long terms, they can have a positive impact on your credit score over time, especially if you use them responsibly.
Whenever you apply for a loan, the lender usually conducts a thorough investigation of your credit reports to assess your creditworthiness. A new application can deduct as little as five points from your FICO® score, but applying for multiple credit accounts could have a compound effect. However, remember that inquiries (and other changes to your credit report) will affect everyone’s results differently depending on their credit history. Some people may 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 your credit score being affected too much. With newer FICO® Score models, tough mortgage, auto, and student loan requests made within a 45-day installment purchase period are combined into one for scoring purposes.
Having multiple types of credit can help improve your FICO® scores because it shows you can manage a range of credit options. So adding a second mortgage could potentially improve the credit mix component of your credit score.
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 prepare your loan for the application process.
Like traditional mortgage loans, second mortgage loans typically require a FICO® score of 620 or greater, although some lenders may offer some flexibility. Regardless, the higher your FICO score, the better your chances of getting a lower interest rate.
Additionally, many lenders only allow you to borrow up to a combined loan-to-value ratio (CLTV) of 80%, meaning the balances on both your primary and secondary mortgages cannot exceed 80% of your home’s value. But again, some lenders may be more flexible than others, and you may be able to borrow up to a 100% CLTV.
In addition to your credit history and home value, lenders 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 applying for a home equity loan or HELOC, check your FICO® scores and review your credit reports to see if you need to make improvements first. Then calculate your DTI and how much equity you have in your home to determine your chances of approval.
If you have questions about eligibility, contact individual lenders to learn more.
Whatever you do, it’s important 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 to improve over time.
myFICO is the consumer division of FICO. For more information, see https://www.myfico.com/credit-education