Are you considering applying for a home equity line of credit? Home equity lines of credit, commonly referred to as HELOCs, represent an attractive type of financing that home owners may decide to take advantage of for a variety of different reasons. HELOCs are commonly used to finance home improvements, to pay off expensive credit card debt, and to pay off student loans, among other purposes.
What Is a HELOC?
In many ways, HELOCs are similar to credit card accounts. Instead of a fixed initial loan amount (as you’d get with a traditional home equity loan), the loan is set up to allow a maximum limit of available funds.
As a result, HELOCs offer flexibility to borrow only as much as you need, leaving you the option to access the remainder of your available limit at a later date if desired.
Unlike credit card accounts, however, HELOCs are secured by your home — and if you default on the loan, then the lender can take your house, as it has been pledged as collateral.
HELOCs resemble credit cards in other ways as well. Both are considered to be “revolving” lines of credit, reported to the credit reporting agencies as “R” type accounts (for “revolving”). And, interest is only incurred if you do not pay your balance in full each month.
Pros, Cons, and Myths About HELOCs
One of the biggest pros HELOCs may offer are their typically attractive interest rates. Interest rates will vary from state to state and lender to lender, so your best bet is to research home equity rates before you decide where to apply for your loan. However, since lenders get the security of your home as collateral, HELOCs boast rates that are much lower than the average credit card account and many other types of personal loans as well. That’s one reason HELOCs are often used to consolidate more expensive debts.
Another great feature of HELOCs is the fact that, like mortgage interest, the interest you’re charged on home equity loans, if any, might be tax deductible (though you should always check with your tax advisor to be sure). Additionally, HELOCs are the only other type of loan (besides a credit card account) where interest is optional, since you can pay the balance in full each month before interest is assessed, if desired.
The biggest con associated with a HELOC, as addressed above, is the fact that by securing the loan with your home’s equity, you could be putting your home at risk in the event of a default. Because of the way these loans are structured, a HELOC is sometimes referred to as a second mortgage.
Unfortunately, if you find yourself unable to pay back your loan, the lender might be able to initiate foreclosure proceedings on your home. The simplest way to avoid this, of course, is to borrow only what you can afford to pay back, and to pay your bill on time.
Finally, a common credit scoring myth has been born out of the fact that HELOCs are considered “revolving” accounts. It’s time to clear things up.
Credit scoring models like FICO and VantageScore are designed to focus on your revolving utilization ratio — that is, the relationship between your balances and credit limits — on your revolving credit card accounts. This means running up high credit card balances relative to your credit limits can lower your credit scores, even if you make all of your monthly payments on time.
Despite some misreporting on the issue, and the fact that both are considered “revolving” debts, HELOCs are not counted when credit scoring models calculate the revolving utilization ratio on your credit card accounts, as a HELOC is not considered a credit card account. Therefore, the fear that a heavily utilized HELOC may negatively impact your credit scores in the same way a nearly maxed-out credit card account might is unfounded.
Related Articles:
- What the HELOC? A Home Equity Loan vs. Line of Credit
- Does Taking on More Debt Boost Your Credit Score?
- Best Home Improvement Loans
John Ulzheimer is an expert on credit reporting, credit scoring, and identity theft. He has written four books on the topic and has been interviewed and quoted thousands of times over the past 10 years. With time spent at Equifax and FICO, Ulzheimer is the only credit expert who actually comes from the credit industry. He has been an expert witness in over 230 credit related lawsuits and has been qualified to testify in both federal and state courts on the topic of consumer credit.
The post How a Home Equity Line Impacts Your Credit Score appeared first on The Simple Dollar.
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