How Does a Home Equity Loan Affect Your Credit?

A home equity loan (HEL) and a home equity line of credit (HELOC) allow homeowners to borrow against the equity they have built in their property. Equity is the portion of your home’s value that you own outright, calculated as the home’s current market value minus any outstanding mortgage balance. This article explores how these financial products affect your credit score.

Immediate Credit Score Impacts

When applying for a home equity loan or HELOC, a lender performs a hard inquiry on your credit report. This hard inquiry is a formal request to view your credit history and can cause a small, temporary decrease in your credit score. While this dip is minor and temporary, it remains on your credit report for up to two years, though its impact on your score diminishes after 12 months.

Opening a new credit account influences the “length of credit history” factor. A new account can lower the average age of all your credit accounts, which may result in a slight score reduction. For a HELOC, the available credit line can initially improve your credit utilization if you do not immediately draw funds, as it increases your total available credit. Conversely, drawing funds from a HELOC increases your credit utilization, similar to how using a credit card balance affects your utilization.

Ongoing Credit Score Effects

Consistent, on-time payments on a home equity loan or HELOC contribute to a positive payment history, which is the most influential factor in credit scoring models, accounting for up to 35% of your score. Regularly meeting payment obligations demonstrates responsible credit management and can steadily improve your credit score over time.

Conversely, late payments, missed payments, or defaulting on a home equity loan or HELOC can damage your credit score. Payments reported 30, 60, or 90 days past due are recorded on your credit report and can lead to score reductions. Such negative marks remain on your credit report for up to seven years, making it more challenging to obtain future credit or secure favorable interest rates.

For HELOCs, managing the outstanding balance relative to the credit limit directly impacts your credit utilization ratio. Keeping the amount borrowed low compared to your available credit is beneficial for your score. A high utilization rate can signal increased risk to lenders and negatively affect your score. Over time, having a mix of different credit types, such as an installment home equity loan alongside revolving credit like a HELOC or credit cards, can positively influence the “credit mix” component of your score.

Home Equity Loans and Your Credit Profile

Home equity loans and HELOCs are secured debts, meaning they are backed by your home as collateral. While this characteristic does not directly affect your credit score calculation, it is a factor for lenders as it reduces their risk. In the event of default, the lender has the right to take possession of the property.

A traditional home equity loan is reported as an installment loan, where a fixed amount is borrowed and repaid over a set period with regular payments. As the loan balance decreases with each payment, it positively impacts the “amounts owed” category of your credit score. In contrast, a HELOC functions as revolving credit, similar to a credit card, allowing you to borrow, repay, and re-borrow funds up to a set limit. The available credit and current utilization of a HELOC are monitored, influencing your credit utilization ratio.

The debt-to-income (DTI) ratio is not a direct factor in your credit score, but lenders consider it when assessing your ability to take on new debt. A new home equity loan or HELOC adds to your total monthly debt payments, which can increase your DTI ratio. Lenders prefer a DTI ratio below 43%. A higher DTI can limit your ability to qualify for future loans, even with a strong credit score, because it indicates a greater portion of your income is already allocated to debt repayment.