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SAN JOSE, Calif.–(BUSINESS WIRE)–If you own your home and have significant equity, you may be able to leverage some of that equity through a home equity loan. home equity or a home equity line of credit (HELOC). Before you do, however, it’s important to consider how taking out a loan or an additional line of credit can affect your FICO® score.
Here’s what you need to know about how home equity loans and HELOCs work and how they impact 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 HELOC are similar in that they both allow homeowners to access a portion of their home’s equity, either in the form of an installment loan or a revolving line of credit.
With a home equity loan, you’ll receive the full loan amount up front and then repay it over a set period, which can range from five to 30 years, with a fixed interest rate.
In contrast, a HELOC is a revolving line of credit, similar to a credit card. After approval, you can draw down your line of credit, usually by debit card, wire transfer, or even a paper check.
During the drawing period, which can last up to 10 years, borrowers are only required to pay interest on the amount they have borrowed. However, if they max out their credit limit, they will have to pay off the balance if they want to continue making draws. Once the draw period ends, they will enter a repayment period, which can last up to 20 years, during which they will pay off the remaining balance.
Unlike home equity loans, HELOCs typically have variable interest rates, which can fluctuate over time. In some cases, however, the lender may allow you to convert some or all of your balance to a fixed rate payment plan.
With both types of credit, you may be able to deduct the interest you pay if you use the loan funds to buy, build, or significantly improve the home used as collateral for the debt. If you use the proceeds for other purposes, however, the interest is not tax deductible.
How do home equity loans and HELOCs affect your FICO® scores?
These second mortgages can affect your credit in different ways, for better or for worse. Here’s a breakdown of what to expect.
If you manage to make your payments on timehome equity loans and HELOCs can help boost your FICO® scores over time.
However, if you miss a payment by 30 days or more, it could have a significant negative impact on your credit. Plus, because you’re using your home as collateral for the loan or line of credit, defaulting on the payment could result in the lender foreclosing the home, further damaging your FICO® scores and leaving you without your primary residence.
Therefore, it is crucial that you ensure that you can pay additional monthly payments before committing.
The amount you owe is another important factor in your FICO® scores. With a home equity loan and a HELOC, the amount you owe is another important factor in your FICO scores. Debt incurred through a home equity loan or HELOC can impact your FICO scores through the Category “Amounts due” of your credit score, under the “amount owing on all accounts” sub-category. The amount of the installment loan still owed, compared to the original loan amount, may also be a factor.
Length of credit history
Adding a new business line to your credit reports will result in the average age of your accounts drop, which could negatively impact your FICO® score. However, because home equity loans and HELOCs often have long terms, they can have a positive impact on your credit over time, especially if you manage them responsibly.
Each time you apply for credit, the lender usually makes a difficult investigation on your credit reports to assess your creditworthiness. A new application can knock less than five points off your FICO® score, but if you apply for multiple credit accounts, it could have a cumulative effect. Keep in mind, though, that inquiries (and other changes to your credit report) impact everyone’s scores differently, depending on their credit history. Some people might see bigger changes than others.
The good news is that if you want to compare interest rates and terms before choosing a lender, you can usually do so without worrying about damaging your credit score too much. With the new FICO® scoring models, mortgage, auto, and student loan inquiries made within 45 days are combined into one for scoring purposes.
Composition of credit
Having different types of credit can help boost 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 scores.
Make sure your credit is ready for a home equity loan or HELOC
If you are considering applying for a home equity loan or HELOC, it is important to understand the requirements and prepare your credit for the application process.
Like conventional mortgages, second mortgages generally require a FICO® score of 620 or higher, although some lenders may offer some flexibility. Either way, 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%, which means your primary and secondary mortgage balances cannot exceed 80% of value. of your house. But again, some lenders may be more flexible than others, and you may be able to borrow up to 100% CLTV.
In addition to your credit history and the value of your home, lenders will also consider your debt to income ratio (DTI), which is the percentage of your gross monthly income that is allocated to repaying your debts. DTI requirements may 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 determine if you need to make improvements first. Next, calculate your DTI and home equity to determine your chances of approval.
If you have questions about eligibility, consider contacting individual lenders to learn more.
Whatever you do, it is essential that you take the time to determine if a home equity loan or HELOC is financially feasible for you and if you can use the debt to improve your financial situation and credit history over time. .
myFICO is the consumer division of FICO. For more information, visit https://www.myfico.com/credit-education