Home equity lines of credit, commonly referred to as HELOCs, represent an attractive type of financing that allows homeowners to borrow against the equity they’ve built in their house Homeowners commonly use HELOCs to finance home improvements, to pay off expensive credit card debt, and to pay off student loans, among other purposes.
HELOC and credit score
Credit scoring models like FICO and VantageScore are designed to focus on your revolving utilization ratio, which is the relationship between your balances and credit limits on your revolving accounts, like credit cards. This means running up high credit card balances relative to your credit limits can lower your credit scores, even if you make all of your monthly payments on time.
So does a home equity loan hurt your credit? Despite some misreporting on the issue, and the fact that a HELOC is considered revolving debt, HELOCs are not counted when credit scoring models calculate the revolving utilization ratio on your credit card accounts. This is because a HELOC loan is not considered a credit card account. The fear that a heavily utilized HELOC will negatively impact your credit scores, like a nearly maxed-out credit card account, is unfounded.
This said, credit monitoring agencies will still watch your payment history on your HELOC. Any missing or late payments will hurt your credit score, so keep an eye on your payment schedule.
What is a HELOC?
In many ways, HELOCs are similar to credit card accounts. Instead of a fixed initial loan amount, as you’d get with a traditional home equity loan, the loan is set up to allow a maximum limit of available funds (like your credit card limit).
As a result, home equity lines of credit offer flexibility to borrow only as much as you need, leaving you the option to access the remainder of your available limit at a later date if desired.
Unlike credit card accounts, HELOCs are secured by your home, and if you default on the loan, then the lender can take your house since it has been pledged as collateral.
HELOCs resemble credit cards in other ways as well. Both are considered to be “revolving” lines of credit, reported to the credit reporting agencies as “R” type accounts (for “revolving”). Interest is only incurred if you do not pay your balance in full each month.
How does a HELOC work?
The loan timeline for a HELOC is broken into two pieces: the draw period and the repayment period.
The draw period
The first period of a HELOC loan is called the draw period, and it usually lasts 10 years. This is the stretch of time you have to use your line of credit, up to your credit limits. You can also repay the money and then borrow again during this period.
The amount of money you can borrow during the draw period is based on your home equity. If you’re unfamiliar with what equity is, it’s the portion of the home you’ve paid off and own outright. You build equity with each mortgage payment. Every time you make a mortgage payment, you pay down your home loan and get more equity in your house. Once you’ve built enough equity in your home, you can borrow against it with a HELOC. Your home serves as collateral for the line of credit in this situation.
The amount of equity you have in your home determines how much you can borrow with a HELOC. When you take out a HELOC, you’ll generally get a set amount of credit to use. You then have the entire draw period to use that amount. If you pay back some of the credit you use during your draw period, it becomes available to you again.
During your draw period, you may not have to make any payments, or you may only need to make the interest payments on the amount you’ve borrowed. You’ll only be charged interest and have to make payments if you borrow from your HELOC, so if you don’t borrow money, you won’t owe anything.
The repayment period
Once the draw period is over, the repayment period starts. This is usually the 20-year period in which you repay any money you borrowed with your HELOC. The repayment period may vary, of course, depending on the terms of your HELOC loan.
So if you still need to pay it back, what’s the draw of a HELOC? The interest rate you’ll get on a HELOC is usually much lower than you’d get with a credit card or personal loan because the money you’re borrowing is secured by your house. Plus, there’s the HELOC-credit score connection. You can use more of your home equity line of credit without it impacting your credit utilization ratio, which is a great option if you have an expensive or large project to complete — or a big purchase to make.
HELOC pros and cons
One of the biggest pros a HELOC may offer is the typically attractive interest rate. Interest rates will vary from state to state and lender to lender, so your best bet is to research home equity rates before you decide where to apply for your loan. Since lenders get the security of your home as collateral, HELOCs boast rates that are much lower than the average credit card account and many other types of personal loans as well. That’s one reason HELOCs are often used to consolidate more expensive debts.
Another great feature of HELOCs is the fact that, like mortgage interest, the interest you’re charged on home equity loans, if any, might be tax deductible (though you should always check with your tax advisor to be sure). Additionally, HELOCs are the only other type of loan (besides a credit card account) where interest is optional, since you can pay the balance in full each month before interest is assessed, if desired.
The biggest con associated with a HELOC, as addressed above, is the fact that by securing the loan with your home’s equity, you could be putting your home at risk in the event of a default. Because of the way these loans are structured, a HELOC is sometimes referred to as a second mortgage.
Unfortunately, if you find yourself unable to pay back your loan, the lender might be able to initiate foreclosure proceedings on your home. The simplest way to avoid this, of course, is to borrow only what you can afford to pay back, and to pay your bill on time.
Should you get a HELOC?
If you need a lump sum of money and have built a good chunk of equity in your house, a HELOC could be a good option for you. This could be for a home renovation, a car purchase, funding college classes for your child or yourself, a large medical bill or any other high-priced expense you can think of.
The biggest risk is that a HELOC can feel like easy money. You generally only need to make interest payments during the draw period, so it’s tempting to use more of your line of credit than you need. Once the repayment period starts, though, you’ll be stuck with a hefty debt to repay.
It’s also important to note that HELOCs are usually variable-rate lines of credit. That means your interest rate will likely change over time, which can make it hard to budget for repaying the amount you borrow. For people who like a clear-cut plan to get out of debt, a HELOC might not be the best option.
That said, a HELOC could be a good option for you if you don’t use more of the credit line than you’ll be able to repay. You’ll get a better interest rate than you would from a credit card, and the HELOC-credit score connection means you won’t have to worry about your credit utilization ratio, a HELOC is usually a better option than a credit card.