Whenever you reach out to a bank, credit union, or any other lender institute for a debt facility, the first thing you need to highlight is your “credit score”.
All these financial institutes are interested in your financial profile. The concept of ranking and ratings of the institutes is not new for customers, but how conversely ratings are allotted to customers is often a complicated concept for the individuals. The credit bureau maintains a credit report for all the customers.
Reporting agencies all around the world, and the US in particular (three of them) maintain credit information for the customers. A credit report is much more detailed profiling of your financials then a credit score.
The credit report includes detailed sections including your personal information such as name, address, tax identification number, etc. your credit history, tax information, court proceedings, and the inquiries made on your credit reports. A “Credit Score” in simple words is a summary of the detailed financial profile for the loan applicant.
Does A Home Equity loan affect your Credit Score?
Answer: Yes and No.
The practical ramification of a Home Equity Loan depends on the nature of the loan facility availed. Often the HELOANS and HELOCs are applied as means of refinancing and the second mortgages, which in turn affect the interest rate and other terms decisions made by lenders. A Home Equity Loan depending on nature can be:
- A Home Equity Loan: with a fixed installment plan, for a lump sum amount, fixed interest rates, and backed by collateral i.e. your home
- A Home Equity Line of Credit or HELOC: with a revolving credit facility, variable interest rate, and backed by collateral i.e. your home
Before we decide on the effects of a Home Equity Loan on your credit score, it is pertinent to know how actually the Credit Score is compiled. What factors make up the credit score? And what weight each of the components carries? And what affects those components.
“A Credit Score is a rating number between the lowest and the highest that depicts a customer’s creditworthiness”. It ranges from a score of 300-850. How the credit score ratings are categorized:
A Credit score of below 580 is “Poor”, from 580-669 “Fair”, from 670-739 “good” from 740-799 “very good” and from 80-850 “excellent.
*A recent development due to current economic situation caused by the pandemic of COVID-19 has caused few institutes to a stricter credit score rating. The new credit score rating deemed the “Good” category will be with a minimum score of 720.
Five main factors make up the final Credit Score of a customer; we’ll detail each factor with the perspective of an applicant with a Home Equity Loan.
Payment History of the Customer:
Your Credit Report is your Financial Profile; it also contains your credit history. It includes all the information about your late payments, defaults, and missed installments. Any late or missed payment marks as part of the customer “negative information”.
The payment history makes up to 35% of your total score. When you apply for a Home Equity Loan, it is worth noting that it is normally a long term “fixed installment” plan. So the missed payment may negatively impact your credit score in the long run.
This is simply a ratio of the available credit limit to the actual credit amount withdrawn. For example, your cumulative debt facility is $50,000 and you have withdrawn $25,000, your credit utilization will be 50%. Paying off a credit card bill from another doesn’t help to improve the credit utilization ratio.
On the other hand, closing all the credit cards or personal loan accounts will decrease the total debt facility which in turn will increase the credit utilization ratio.
A Home Equity Loan is a lump sum payment loan, if it is used to pay off the credit card bills or personal loans it may help in credit utilization.
A HELOC on the other hand plays a key role in your credit utilization as it is a revolving credit facility and the impact keeps changing with payment and withdraws. A credit utilization ratio of less than 30% is deemed safe by lenders.
Length of Credit History:
The length of your credit history and your payment history are correlated in way. Generally in credit scoring the longer the length of your credit history, the better it is for your Credit Score.
Keeping a clean payment history is an uphill task; fluctuations in your income stream, economic downfall, personal problems, or any other reason to default on your loan will negatively impact your Credit Score.
A Home Equity Loan doesn’t affect your length of credit history; in fact, it is considered a positive point in your Credit Score.
However, keeping installments payments on time for both HELOAN and HELOC for such a long period is difficult. The Length of the credit history accounts for 15% of your total Credit Score.
The Credit Mix:
As the name suggests, it is a combined score of all the debt facilities you have availed over the years. The Credit Mix includes all of your credit cards, student loans, the first mortgage, etc.
The credit mix weighs 10% in your overall Credit Score. Often customers opt for applying for new credit cards to increase their Credit Mix, which is a futile exercise.
Generally, the lenders consider a diversified credit mix as a positive sign. A Home Equity Loan will add up to your Credit mix, so the initial impact on your Credit Score will be positive.
As in the discussion of other points, it is also a relative measure, keeping a well-diversified portfolio of debts is one thing, and maintaining a clean sheet another.
Any new debt account opened, a new credit card issued against your account, or a personal loan adds up as a new credit facility.
As the number of accounts increases the impact is more negative. The New Credit weighs 10% in your credit score. So applying for a new Home Equity Loan will definitely put a red dot on your Credit Score.
Any new credit account also accompanies a “hard inquiry” by the lender that also negatively impacts your Credit Score. Moreover, as your application gets rejected time and again, the number of “soft” and “hard” inquiries increases.
A Credit Score can be defined as a make or break factor in your loan appraisal. As we discussed the factors combining in the making of a credit score, it is important to put attention to each of the factors. The effects of a Home Equity Loan on your Credit Score are not a straightforward answer.
As a customer, you cannot foresee the future circumstances that eventually will affect your credit score after applying for a HELOAN. There are certain factors, however, that as a loan buyer you can consider to improve your Credit Score:
- Check Your Credit Score and Credit Report regularly; you can improve the Credit Score Status only if you know where deficiencies lay.
- Make your loan installment payments on time.
- Avoid opening too many debt accounts within a certain time limit.
- Your corrective measures towards your Credit Score will show up gradually, so do not hasten things into it.
- If you are not using a credit card to its limit, do not cancel it. Unless you are replacing it with another long-term loan like a HELOAN or HELOC.
- A Home Equity Loan either fixed or revolving like HELOC will surely increase your debt limits which in turn will increase your credit utilization ratio.
If you are applying for a Home Equity Loan, it is going to affect your Credit Score in many ways. The Idea of paying off small debts like a credit card, student loan, or even a car loan with a long-term fixed-rate loan is sensible. But remember if you default your dream house is on the line.
A Home Equity Loan comes with a long term payment plan from 5 to 15 years; to keep the Credit Score up during that period will be a difficult task.
As we discussed the Credit Score comprises of different factors, any of the fault lines causing a significant drop in the Credit Score might cause you a foreclosure.
The temptation that comes with the full utilization of a Home Equity loan or even with a Home Equity Line of Credit can have an adverse impact on your Credit Score overall.
A Credit Score can have a large impact on your closing deal with your lender, especially deciding on the interest rate. The lenders review your Credit Score over the years, and as we discussed the payment history makes for 35% of the total Credit Score.
The impact of A Home Equity Loan might be so adverse in the beginning, but in the future, if you apply for a new credit card or the limit extension the consequences can be damaging.