A home equity line of credit (HELOC) is a popular way to pay for home improvements, major repairs or other big expenses. More than 1 in 10 U.S. consumers plan to apply for a new home equity line of credit in the next year, according to the Q3 2022 TransUnion Consumer Pulse study, and an additional 5% plan to refinance an existing HELOC.
If you’ve built up value in your home, taking out a HELOC may be tempting. Like all forms of debt, it can be a useful tool, but should be managed carefully.
Here is an overview of what a HELOC is and how it can impact your credit:
What is a HELOC?
A HELOC is a financial product that essentially acts as an additional mortgage on your home. Your lender provides you with a revolving line of credit, somewhat similar to how a credit card works. But instead of an unsecured loan like a credit card, with a HELOC you use your home as collateral.
When you take out a credit card, your lender will give you a credit limit — a maximum amount you’re allowed to borrow on the account. With a HELOC, you’re allowed to draw from a certain percentage of the equity you have in your home. The equity in your home is the difference between the value of your home and how much you owe on your mortgage. For example, if your home is worth $400,000 and you have $150,000 left to pay back on your mortgage, your equity is $250,000.
Lenders may use your credit history, among other factors, to determine how much they’re willing to lend you, along with the interest rate they will charge. There may be fees you have to pay when you take out a HELOC, similar to those when applying for a standard mortgage. So make sure you’re aware of these costs and communicate with your lender if you have any questions if you’re considering applying for a HELOC.
How does a HELOC work?
HELOCs have what are called a draw period and a repayment period. The draw period is the time when you can spend the maximum amount available on your credit line. The draw period commonly lasts for 10 years, but can be more or less depending on your lender. Similar to a credit card, you’ll be given a set credit limit — your credit limit is determined by your lender and is a percentage of the equity you have in your home. You’re usually only liable for interest payments during the draw period, but you can pay down the principal if you’re able to.
The repayment period starts when the draw period ends. This is when you’ll need to start paying down any remaining balance as well as interest payments. Typically, you have 20 years to pay down the balance.
HELOC interest rates are usually variable, so they can change. You need to be financially prepared if interest rates rise because your HELOC payments may become more expensive.
How does a HELOC impact my credit score?
Taking out a HELOC may involve a credit check, which could result in a hard inquiry and may cause a temporary dip in your score. Missed payments on a HELOC can negatively impact your credit score as well. Your payment history is one of the most important credit score factors, so it’s important to stay current on your HELOC payments.
HELOCs are a revolving line of credit and credit score models use the balance as a part of your credit utilization percentage in their credit score calculations. Credit utilization is a major credit score factor, so keeping your balance as low as possible is important. Additionally, you should still be mindful of a growing balance as it could impact your ability to pay other important bills and loans, including your regular mortgage payment if you have one.
HELOCs can be a useful tool to help with household repairs and renovations or other needs outside the home, like debt consolidation. It’s important to practice good credit and financial habits during the draw period so that you’re financially prepared to pay down your HELOC as efficiently as possible.
Even if you’re in the process of paying off debt, you should consider keeping a modest amount of savings on hand in case of emergencies. You can learn tips on how to manage your debt and save in our blog post, Save or Pay Off Debt? Here’s What to Consider.