Your home equity is the amount of your home that you own – in other words, the market value of your home minus the amount of principal that you owe on your loan. For many Americans, it's one of their largest financial assets.
If you need money for various projects and expenses, your home equity can be a useful source of collateral. You can draw on this asset with a home equity loan or a home equity line of credit (HELOC).
While home equity loans are usually lump sum loans with fixed payments and interest rates, a HELOC acts more like a credit card limit. You can draw against your HELOC up to that limit and replenish the supply of available credit by paying off part of the HELOC and the associated interest.
Home equity loans can be attractive for moderately large expenses. Currently, home equity loan interest rates are near 6% and HELOC rates are approximately 6.7% – relatively low rates thanks to the use of your home as collateral. By contrast, average personal loan rates are closer to 10% to 12% and average credit card rates are over 17.7%.
Since home equity borrowing is another form of credit, your credit score will be affected – but by how much? A new survey from LendingTree shows a minimal effect, as long as you use your loan or line of credit responsibly.
According to the survey, home equity borrowing averaged only a thirteen-point decline in the initial borrowing stages. The decline bottomed out in an average of 158 days (just over five months) and recovered in almost the same amount of time (163 days on average). After the recovery period, average scores continued to move higher as borrowers paid off their loans.
Given the average borrower's credit score of 735, a thirteen-point decline is less than 2%. A small and temporary decline in a credit score is a pretty good trade-off for access to needed cash, especially when your credit score is likely to be higher within a year after you take out the loan.
How does a HELOC affect your credit score, and why does it rebound on average? The key is using your home equity loan or HELOC responsibly.
The most important factors in calculating a credit score are on-time payments, how much of your credit limit you're using (overall and on any one account), the type and length of credit that you use, and your total debt load.
The initial drop in credit score comes from the increased debt load and a shorter average length of credit account – although with a HELOC, you can change the debt load effect based on how much of your line of credit you use.
Your credit score increases as you make payments on-time and reduce your credit utilization and overall debt load. It's a further bonus if you're showing responsible behavior with different types of credit like credit cards, home equity loans, and any other installment loans.
Responsible borrowing takes a broad perspective on your finances. Your credit score is affected by every account that involves borrowing money. You can easily wipe out the positive aspect of home equity borrowing by acting irresponsibly in other areas of borrowing – like running up large credit card bills or missing payments of any type.
Cautions LendingTree Senior Research Analyst Kali McFadden, "Home equity loans and lines of equity can be very a cost-effective way to borrow money, and the relative stability we see in the credit scores of users indicates that people are using them in a way that's very manageable for them. They're not drawing down too much credit or making large payments because of budget shortfalls."
As the LendingTree survey shows, home equity borrowing can be a great way to get cash with minimal damage to your credit score. Don't squander the advantages with irresponsible behavior on your home equity loan – or any other credit source.
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