A HELOC stands for a home equity line of credit, and if you decide to take one out to access funds, it could directly affect your credit score. Additionally, taking out a HELOC requires a lender to run a hard inquiry—this can temporarily decrease your credit score by a few points.
There are multiple factors that can directly affect your credit score, from payment history to credit mix (the different types of accounts you have). Some items, such as HELOCs, can be slightly more difficult to understand within the context of credit scores, but they can still have an impact depending on how you manage your account.
In this article, you will learn about:
- What a HELOC is
- Why someone would open a HELOC
- The benefits of a HELOC
- The risks of a HELOC
- HELOC affecting credit utilization
- How a HELOC can improve your credit
What is a HELOC?
A home equity line of credit (HELOC) is a line of revolving credit where you borrow against the value of your home.
For example, let’s say you are looking to pay off a large balance, such as medical bills, but you don’t have cash on hand to pay for it now. When you’re in a pinch, you may be able to borrow against your home’s equity — the difference between your home’s current market value and what you still owe towards your mortgage. This difference can become accessible to you as a line of credit. Lenders will let you borrow up to a certain percentage of this amount--around 60-85%, depending on factors such as your credit score and debt-to-income ratio.
Like many other forms of credit, HELOCs come with interest rates. These can either be fixed (the same flat rate for the life of the loan) or variable (the percentage changes due to market fluctuations) which affects how much you owe back in interest.
This is where having a good credit score can help you earn higher amounts in credit and land lower interest rates. When you enroll in Chase Credit Journey®, you can view your free credit score and learn more about what it means so that you can make an educated financial decision about opening a HELOC.
Why would someone open a HELOC?
There are sound reasons that you might want to choose a HELOC as opposed to other lines of credit, like personal loans, for a home improvement. Making upgrades to your home can help increase its value and bring in more interest from future buyers if you plan to sell your home. Depending on your lender, it’s possible that you can also deduct the interest paid to put towards building or improving your home. Money spent towards home improvements may even be tax deductible, helping you to invest your money into your home.
HELOCs generally come with lower interest rates compared to some other types of loans. For example, you may want to take out a HELOC to pay off credit card debt that comes with higher interest rates. You could refinance your higher interest rates associated with your credit card by using a HELOC to pay off those debts and then paying off the HELOC loan that comes with a lower interest rate.
Note: Always check with your lender to make sure you understand the terms of the loan before taking out a HELOC.
What are some benefits of a HELOC?
As you can see, HELOCs can be quite beneficial depending on your financial situation. They can:
- Provide an additional line of credit — this can be helpful if you are in need of emergency-related funds, such as large medical bills.
- Come with lower interest rates — other lines of credit, such as credit cards, often come with higher interest rates.
- Positively affect your credit score — if you manage your account responsibly, you can help build your payment history, a major factor when determining your credit score.
- Help improve the value of your home — if you’re using a HELOC to upgrade or rebuild, you could potentially increase the value of your home and sell it at a higher price to future buyers.
- Act like a second mortgage — a HELOC won’t affect your existing mortgage payments.
What are the risks?
HELOCs can be helpful for a wide range of reasons, but it’s important to understand the risks associated with them before making the decision to take out this type of credit. These include, but are not limited to:
- The potential to put your home at risk — because your home is considered collateral, not making your payments could make your home vulnerable to foreclosure.
- The potential to reduce your home’s equity — if the prices of homes drop, it’s possible you could owe more than what your home is valued at.
- Higher payments after the pay period ends — the draw period is the duration that you can take money out from your available credit. During this time you will only need to pay the minimum payment back each month. Once the draw period is up, you will need to repay the loan and interest in the agreed upon period of time.
- The potential to negatively impact your credit score — if you don’t make your payments on time, your credit score may decrease.
Additionally, keep in mind that not all lenders will offer HELOCs.
Does a HELOC affect credit utilization?
Credit utilization is the ratio of how much you use of your credit against the total amount of credit available to you. The more you use up your total line of credit, the higher your credit utilization ratio.
A HELOC could help you improve your credit utilization if you decide to use the funds from the HELOC to pay off high credit card balances. Paying off these large bills can potentially lower your credit utilization and may improve your score. However, keep in mind you will still need to pay the funds from your HELOC back later. If you aren’t careful, this could elevate your financial risk.
Can a HELOC help improve your credit?
If you make your payments on time, a HELOC has the potential to improve your credit. Because payment history is a crucial factor in maintaining a good credit score, you’ll want to make sure you’re meeting your monthly payments. By increasing your credit mix by adding a diverse account and making payments on time, you could positively improve your credit score and reap the many benefits associated with this.
It's always important to carefully manage your funds, especially when it comes to HELOCs — you could see not only a decrease in your credit score but you could also be putting your home at risk. Making your payments on time and budgeting appropriately can help benefit you and may improve your credit.
In conclusion
While not always the first option when it comes to accessing lines of credit, HELOCs can be a sound option depending on your specific financial needs and current situation. Whether you’re looking to improve your home, pay off large balances or secure lower interest rates, a HELOC could be the right choice for you as long as you consistently make your payments on time.
