What is a HELOC and how does it work?

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A home equity line of credit is a type of revolving credit available to a homeowner with a maximum threshold that’s secured by their house. This type of loan typically comes with much lower interest rates than credit cards and even other types of personal loans.

Many homeowners take advantage of home equity lines of credit, however, not every homeowner automatically qualifies for a HELOC—you’ll need to have a high credit score.

To qualify for a HELOC, borrowers typically need a FICO® of at least 620.

What is a HELOC?

A home equity line of credit is like a second mortgage on your home. You’re essentially borrowing against your home—often to fund large purchases such as home renovations and improvements. The loan is offered as revolving credit, similar to a credit card.

This means you have a maximum amount available to access every month that you can choose to use or not use. A HELOC offers a lot of flexibility as it gives you access to funds to use whenever you need them.

When you tap into your HELOC, you can pay it off on a monthly basis or carry a balance forward and pay interest. Your HELOC interest rate will depend on factors such as your credit score, debt-to-income ratio, income and more. Additionally, most HELOCs come with an adjustable interest rate. The baseline rate is decided based on your credit and then has a markup to adjust to current market rates.

The amount of credit you get with your HELOC is tied to your home’s equity. Equity is the amount your house is worth over what you currently owe on it. For this reason, most people can’t get a HELOC until they’ve had their property for a few years and built up some equity.

In fact, most lenders require that you have at least 15-20 percent equity in your home before giving out a HELOC. And, of course, you can also get a HELOC if you own your home in full.

HELOCs are often granted for a specific period, most commonly 10 years. This means you have 10 years to use the funds available at your predefined variable interest rate. After the 10 years pass, you may have to reapply or your HELOC account may close.

Credit score requirements for HELOC

Experts suggest that you can get a HELOC with a credit score as low as 620. However, your chances will improve if you have a score of at least 680.

Of course, your credit score isn’t the only thing lenders look at for a HELOC application. The requirements for a HELOC are:

• Minimum credit score (620-860)
• A debt-to-income ratio of 40% or less
• Home equity between 15-20%

Will a bad credit score affect my HELOC interest rate?

Your credit score will directly impact your HELOC interest rate. It’s estimated that you need a credit score between 720-740 to secure the best interest possible on your HELOC. The higher your credit score, the lower your HELOC interest rate will be.

If you have a credit score between 620-720, you can still get approved for a HELOC. However, lenders will probably want to see you shine in the other qualification areas (high equity and low debt-to-income ratio), and your final interest rate will be higher.

How a HELOC affects your credit

A HELOC can impact your credit score in a few ways, from the effect that the application process will have on your credit to having a current HELOC as a tradeline on your credit report.

1. When you apply for a HELOC

When you apply for the HELOC, you might see an impact on your credit score. Your lender may do a hard credit pull of your credit report to evaluate your creditworthiness and ability to pay the loan. A single hard inquiry will have a minimal impact on your credit. You’ll likely see your credit score drop between 5-10 points initially, but it will typically bounce back after a couple of months.

Where the potential problem comes up is if you have multiple hard inquiries. Having several hard inquiries in a short period can cause your credit score to go down, and it might take a while for your score to bounce back from this. When you’re applying for your HELOC, avoid applying for other types of credit or loans (auto loans, credit cards, etc.) for a while.

Note that some lenders only pull a soft inquiry into your credit for a HELOC if they already have enough information on file from your mortgage payments. A soft inquiry won’t affect your score.

2. While your HELOC is open

While your HELOC is open, any activity on it can be reported to the credit bureaus. So if you make payments on time and in full, this can improve your credit history and potentially increase your score. Conversely, missing or making late payments can negatively impact your credit.

Consider setting up automatic payments for the minimum amount so you never miss a payment on your HELOC.

3. After your HELOC closes

When you close your HELOC, prepare to possibly see a dip in your credit score. Credit utilization is one of the five factors making up your credit score, and it accounts for 30 percent of your score. Credit utilization is the amount of credit you use each month versus the amount available to you. Generally speaking, credit utilization above 30 percent can harm your credit score.

Let’s say you have a $10,000 HELOC and a $10,000 credit card. On average, you spend $4,500 on your credit card every month. When you have $20,000 worth of credit available to you, that’s utilization of 22.5 percent, which is healthy. However, once your HELOC closes, your credit utilization rises to 45 percent. As a result, you could see a drop in your credit score.

HELOCs versus home equity loans—which are better?

HELOCs and home equity loans may sound similar, but they’re quite different from each other. A HELOC is revolving credit, which means it’s always available to you but you only tap into it when you need it. If you don’t take any money out, you don’t need to make any payments.

In comparison, a home equity loan is a loan that you apply for and receive all the money up front. After receiving your money, the repayment period immediately starts. You make payments on a fixed interest rate, which means you know exactly how much you’ll pay every month and how long your repayment period is.

When it comes to deciding which one is right for you, there are a few factors you need to consider. The first is whether you need money right away or want access to capital for future projects. Both options offer the ability to access the money immediately, but only a HELOC can serve as a “safety cushion” for when you need cash in the future.

The other key factor is the variable versus fixed interest rate. If you need money right away but prefer the stability of the same monthly payment, you might choose a home equity loan versus a HELOC.

Ways to improve your credit before applying for a HELOC

There are several steps you can take to improve your credit before applying for a HELOC.

• Pay down your debts: Getting rid of your debts will help you improve your debt-to-income ratio as well as your credit score.
• Reduce your credit utilization: Try to keep your credit utilization at 30 percent or less so it doesn’t negatively impact your credit score.
• Make all your payments: Setting up auto payments can help you ensure you never miss or make a late payment again. Even a single late payment can show up on your credit report and bring down your credit score.
• Work with a credit repair company: CreditRepair.com has credit consultants who will review your credit report with you for any errors and file disputes with the credit bureau on your behalf. A mistake on your credit report could be keeping your credit score down without you knowing it.

Remember, a higher credit score means a lower HELOC interest rate, so these steps can potentially save you hundreds (or thousands) in interest!

Reviewed by Anthony Moore, Credit Consultant and Trainer at CreditRepair.com.

Anthony Moore started working for CreditRepair.com November of 2016. Anthony Moore started as a credit advisor, and quickly advanced to to helping members get caught up on their overdue payments. In addition to reviewing and writing content for CreditRepair.com, Anthony assists other credit advisors with approvals and supports the credit repair process.

Note: The information provided on CreditRepair.com does not, and is not intended to, act as legal, financial or credit advice; instead, it is for general informational purposes only.