Home equity is the portion of your home that you own free and clear of any mortgage. Having home equity is generally considered a good thing – it shows you’ve paid down your mortgage and built up value in your property. However, some people worry that tapping into their home equity through loans or lines of credit can negatively impact their credit scores. Here’s what you need to know about how home equity can affect your credit.
What is home equity?
Home equity is calculated by taking the current market value of your home and subtracting any mortgage debt or other liens against it. For example, if your home is worth $300,000 and you owe $150,000 on your mortgage, your home equity is $150,000.
Home equity is built up over time as you pay down your mortgage principal and as your home appreciates in value. Having a sizable chunk of home equity shows lenders that you’ve invested a good deal into your home.
Why do people tap into home equity?
There are several reasons homeowners tap into their home equity:
- Cash-out refinance – Refinancing for more than what you currently owe to access equity in cash.
- Home equity loan – A second loan using your equity as collateral.
- Home equity line of credit (HELOC) – A revolving credit line also using home equity as collateral.
- Home improvements – Remodeling, renovations, repairs, etc.
- Debt consolidation – Paying off higher interest rate debts.
- Major purchases – Funding a college education, wedding, medical bills, etc.
Tapping home equity can give you access to funds for big expenses without having to sell your home or take out an unsecured loan at a higher interest rate.
Does using home equity hurt your credit?
Simply having home equity does not hurt your credit – it actually helps! Having substantial equity shows lenders you have assets and makes you look more creditworthy.
However, how you use your home equity can impact your credit to varying degrees:
Cash-out refinance
A cash-out refinance converts home equity into cash by replacing your existing mortgage with a new, larger mortgage. This shows up on your credit report as a brand new mortgage account. That can lower the average age of your credit history, which accounts for 15% of your FICO credit score.
A large new mortgage can also impact your credit utilization ratio, which makes up 30% of your score. It may drive up your total debt compared to available credit limits.
However, as long as you make timely payments, a cash-out refinance alone shouldn’t drastically damage your credit score in most cases.
Home equity loan or HELOC
Home equity loans and HELOCs function like second mortgages. They show up on your credit report and factor into your credit utilization. As with a cash-out refinance, taking out a large home equity loan could impact your credit mix and lower your average account age, especially right after opening it.
The good news is that responsible use of home equity loans and HELOCs – making on-time payments and keeping your utilization low – demonstrates good credit management. In the long run, they can actually build your credit history when used wisely.
Tips for minimizing credit damage
If you’re concerned about home equity impacting your credit, here are some tips to minimize potential damage:
- Shop around for the lowest rates and fees so the debt burden is minimal.
- Avoid tapping more equity than you need.
- Pay down balances quickly to reduce long-term interest charges.
- Make payments on time every month – set up autopay if it helps.
- Keep credit utilization below 30% on all accounts if possible.
- Don’t close old credit cards as that can lower your credit age.
- Watch your credit reports for any reporting errors.
Being smart about how much you borrow and making payments on time will go a long way in minimizing short-term credit score dips. Your score should rebound as you pay down the debt over time.
Weighing the pros and cons
As with any major financial decision, you’ll need to weigh the benefits of tapping home equity versus any potential credit impacts:
Pros
- Access cash for major expenses, projects, etc.
- Consolidate higher interest rate debts.
- Potentially tax deductible interest.
- Often lower rates than unsecured loans.
- Can build your credit if used responsibly.
Cons
- Large new debt can negatively affect credit scores.
- Closing costs and fees reduce amount available.
- Risk losing home if unable to repay.
- Variable rates can rise over time.
- Reduces your available home equity.
Generally, if you only borrow what you need and can comfortably afford the payments, tapping home equity judiciously is unlikely to do major damage to your credit, and over time a well-managed account could help build your credit history.
Alternatives to preserve your credit
If you want to avoid credit impacts completely, here are a few options to consider instead of tapping home equity:
- 401(k) or other retirement plan loans – No credit check and interest paid goes back into your account.
- Borrowing from family – No credit impact, but can cause relationship issues.
- Credit cards or personal loans – Higher rates but will only affect your credit utilization.
- Selling assets – Sell investments, unnecessary belongings, second home, etc.
- Credit counseling – Work with a non-profit to pay down debts and improve credit.
However, in many cases, responsibly using home equity is a better option than resorting to less ideal alternatives. Talk to a financial advisor to understand all your options.
The bottom line
Tapping into home equity can absolutely be done without devastating your credit, especially if you only borrow what you need and make payments on time. Any credit impacts are usually short-term. With wise use, a home equity loan or line of credit can actually demonstrate positive credit management and build your credit profile over the long run.
Frequently Asked Questions
Does a home equity loan affect your credit score?
A home equity loan can have a minor negative impact on your credit score in the short term. Average age of accounts and credit utilization may take a slight hit. However, responsible use will build positive credit history over time.
Is home equity considered debt?
Home equity itself is not debt – it represents your ownership stake in your home. However, when you borrow against home equity via a loan or line of credit, that does create a new debt obligation.
Does home equity increase your net worth?
Yes, home equity is an asset that increases your overall net worth. Net worth is calculated as assets minus liabilities, so home equity boosts net worth as it reduces mortgage debt.
Is it smart to use home equity to pay off debt?
Using home equity to consolidate high-interest credit card or other consumer debt into a lower rate product can be smart. But avoid tapping equity to pay everyday expenses – the risk of foreclosure makes this very unwise.
Does a home equity loan require a credit check?
Nearly all lenders will conduct a hard credit inquiry before approving a home equity loan or line of credit. Good credit is needed to qualify, though requirements are not as strict as for a primary mortgage.
Table Comparing Home Equity Loan and HELOC
| Factor | Home Equity Loan | HELOC |
|---|---|---|
| Access to funds | Single lump sum | Revolving credit line |
| Payments | Fixed for loan term | Interest-only during draw period |
| Rates | Fixed | Variable |
| Costs | Closing costs | Upfront fees plus closing costs |
| Tax benefits | Potentially tax deductible | Potentially tax deductible |
| Best for | One-time large expenses | Ongoing flexibility |
Conclusion
Using home equity strategically through loans or lines of credit can provide financial flexibility. While it may cause minor short-term credit impacts, responsible management of home equity debt can actually build your credit profile over time. Weigh the pros and cons thoroughly based on your specific situation and goals.