With a red-hot housing market, many homeowners have seen a significant increase in home values. According to an analysis by CoreLogic, U.S. homeowners with mortgages saw their home equity increase by $3.2 trillion in one year, for an increase of 29.3% year-over-year.
With such a large gain in equity, many people are considering using home equity loans to finance home improvement projects or pay for medical expenses. But how does a home equity loan affect your credit score? By understanding the different ways home equity loans can impact your credit, you can take steps to limit the damage and maintain your credit score.
- Home equities increased by $3.2 trillion in one year.
- Tapping into your home’s equity allows you to get cash for major expenses.
- Applying for a home equity loan can impact your credit score in different ways.
- Responsible credit use can mitigate the effect on your credit.
What Is a Home Equity Loan?
A home equity loan is a tool you can use to get cash by borrowing against the equity you established in your home. You get a lump sum of cash and repay it over a set period of time, such as five to 15 years. Home equity loans are secured by your home; because they require collateral, they tend to have lower interest rates than unsecured loans.
With many home equity loan lenders, the maximum you can borrow is 80% of your home’s equity.
Five Ways a Home Equity Loan Can Affect Your Credit
Your credit score plays an important role in your financial life. Your score is based on the information on your credit report, and it’s a financial representation of how well you handle credit. Lenders use credit scores to determine your eligibility for loans and credit cards and to decide what terms you’ll receive.
If you’re considering a home equity loan to finance a dream vacation or to remodel your kitchen, you should know that the loan can affect your credit in the following ways:
1. Credit inquiries can impact your score
Whenever you apply for a form of credit, such as a loan or credit card, the creditor will perform a hard credit inquiry. Each hard credit inquiry can cause your score to drop. How many points your score will decrease is dependent on your existing credit profile, but for most people, new inquiries lower credit scores by fewer than five points.
Though it’s always wise to get rate quotes from several lenders, be aware that each credit inquiry can affect your score. To minimize the impact, limit rate quote requests to a shopping window time frame. In general, inquiries for the same type of loan made within 14 to 30 days are counted as one inquiry rather than several, reducing the effect on your credit.
2. New credit lowers your score
When you take out a loan, such as a home equity loan, it shows up as a new credit account on your credit report. New credit affects 10% of your FICO credit score, and a new loan can cause your score to decrease. However, your score can recover over time as the loan ages.
3. A home equity loan changes your credit mix
Ideally, your credit report should show a mix of different loans and credit cards; lenders like to see that you can successfully manage multiple forms of credit. In fact, your credit mix determines 10% of your FICO score.
If your credit report is limited to—or mainly composed of—credit cards, adding a home equity loan can improve your credit mix and actually positively impact your credit.
You can review your credit reports from each of the three major credit bureaus—Equifax, Experian, and TransUnion—for free at AnnualCreditReport.com.
4. Consolidating debt can improve your credit utilization
Depending on how you use your home equity loan, you could improve your credit. Your credit utilization—the amount of available credit that you use—makes up 30% of your FICO credit score.
If you use a home equity loan to consolidate credit card debt, you’ll eliminate the balances on your revolving credit—and increase your score in the process.
5. On-time payments can boost your credit
Timely payments are the biggest factor in determining your FICO credit score; your payment history makes up 35% of your score. Over the life of your home equity loan, making all of your monthly payments on time will help establish a positive payment history and even improve your credit.
What Can I Do to Improve the Odds of Getting a Home Equity Loan?
If your credit score isn’t good enough to qualify for a home equity loan, some lenders will allow you to apply with a cosigner to improve your odds of getting a loan.
Are There Risks to a Home Equity Loan?
Yes. Your home could be foreclosed on if you don’t pay off a home equity loan, so take out the loan with care and use it for something that will increase your home's value.
Does My Credit Score Affect the Interest Rate on a Loan?
Just as they do for other mortgages, your employment history, income, and credit score all play a part in determining your eligibility for a home equity loan as well as the interest rate you'll pay. A higher score means there's less of a risk you'll default on the loan. Therefore, the lender can offer a lower rate.
The Bottom Line
If you take out a home equity loan and are concerned about damage to your credit, there are ways to mitigate the impact:
- Make all of your monthly payments on time.
- Pay down the balances on your revolving credit to reduce your credit utilization.
- Only apply for credit when you really need it to limit credit inquiries.
Though taking out a home equity loan can cause your credit score to drop, the impact is usually fairly small, and you can improve your score over time by managing your credit responsibly.