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Pros and Cons of a HELOC

Kathryn Pomroy
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Quick Answer

A home equity line of credit, or HELOC, is a type of loan that is secured by your home. Like any type of financing, it comes with risks and rewards.

<p> FICO Scores are used by 90% of top lenders, but even so, there’s no single credit score or scoring system that’s most important.</p><p></p><p> In a very real way, the score that matters most is the one used by the lender willing to offer you the best lending terms. That, in turn, may depend on the type of loan or credit you need, your credit history and the lenders you seek out.</p><section id=

Why There Isn’t a Single, Most Important Credit Score

There are several reasons why there isn’t one credit score on which consumers should place their sole focus.

No Score Is Universal

No single credit score can be considered most important because it's practically impossible to know exactly which score any given lender will see when they process your credit application. Lenders have considerable choice among commercial credit scoring systems, or scoring models, including at least 16 different versions of the FICO Score and four versions of the rival VantageScore®.

The Same Number Can Mean Different Things

The most common scoring models, VantageScore 3.0 and 4.0 and the general-use versions of the FICO Score, assign three-digit scores on a range of 300 to 850, with higher scores indicating greater creditworthiness. Even when they share the same scale, however, it’s important to know that a specific score can mean something different depending on the scoring model, and even which version of that model, is used to generate it.

A “Good” Score Depends on the Lender

Lenders typically select one or more scoring models after testing its effectiveness with their loan offerings and target customers. While one lender might fine-tune its scoring methods to identify the most creditworthy of borrowers, another might focus on riskier borrowers, and use scoring to better understand them. Some lenders even feed scores from the FICO Score or VantageScore models into their own custom-built scoring models to better understand potential customers.

Scores Can Vary by Data Source

Commercial scoring models generate scores using credit report data from one of the national credit bureaus (Experian, TransUnion or Equifax). Because your credit reports at all three bureaus are rarely identical, it’s virtually impossible to predict what score a lender will receive or use when deciding if you qualify for a loan, or when deciding what interest rate and fees to charge you. Recognizing this, many lenders use scores generated from two or even all three bureaus when performing credit checks.

Most Important Credit Scores by Role

The variety of credit score models and versions available today can make it tough to predict which score any lender will use, but different models and versions are more popular than others for specific lending applications. Here’s a list of the scores you’re likeliest to encounter in various settings.

Most Important Credit Score for Monitoring Your Credit

FICO Score 8. The FICO Score 8 is currently the most widely used version of the FICO Score. You can check it for free from Experian and other sources, so it’s easy to track. While there’s no guarantee the score you see when you check yourself will be identical to the one a given lender will see, FICO Score 8 will give you a good idea of how lenders will view your credit profile.

Most Important Credit Score for a Credit Card Application

FICO Bankcard Scores 8 and 9. The FICO Bankcard Score, which debuted in 1993, is fine-tuned for determining the creditworthiness of credit card borrowers. It uses a scale range of 250 to 900, and versions 8 and 9 of this score are widely used by credit card issuers. You can get your Bankcard Score through the three national credit bureaus and possibly your credit card company.

Most Important Credit Score for a Mortgage

FICO Scores 2, 4 and 5. Known as “classic” FICO Scores, these older versions of the generic FICO Score are widely used by mortgage lenders because they are included in criteria that make conforming mortgages eligible for purchase by the government-backed mortgage-funding corporations Fannie Mae and Freddie Mac. They use the traditional 300 to 850 score range.

  • FICO Score 2 is the “classic” FICO Score version available from Experian.
  • FICO Score 4 is the version of the classic FICO Score offered by TransUnion.
  • FICO Score 5 is the Equifax version of the “classic” FICO Score.

Most Important Credit Score for an Auto Loan

FICO Auto Score 8 and FICO Auto Score 9. Tailored for use by providers of auto financing, the FICO Auto Score uses a score range of 250 to 900. Versions 8 and 9 of the model are widely used by auto lenders, and available from all three national credit bureaus.

How to Improve Your Credit Score

While uncertainty about which score will apply to a credit application may seem nerve-wracking, the good news is that all scoring models tend to respond favorably to the same set of good credit management habits, including:

  • Pay your bills on time, especially all debt payments. Payment history accounts for about 35% of your FICO Score, making it the most influential factor in your scores.
  • Keep credit card balances low. Lenders see high credit card balances as an indicator of risk, so scoring models will lower scores if your total card balance exceeds about 30% of your total borrowing limit. That said, keeping balances under 10% of limits can help you achieve top scores. Credit utilization accounts for about 30% of your FICO Score.
  • Bide your time. Credit scoring models reward borrowers with long track records of responsible credit management. In other words, if you keep up with your payments and mind your balances, your credit scores will tend to improve over time. The ages of your open credit accounts, which serve as a measure of experience, are responsible for about 15% of your FICO Score.
  • Maintain a healthy credit blend. Scoring models tend to boost the scores of who can handle multiple types of debt at the same time. A mix of installment loans with fixed payments (student loans, mortgages, auto loans and the like) and revolving credit (accounts like credit cards that allow charging against a set borrowing limit) will tend to increase your score. Credit mix is responsible for about 10% of your FICO Score.
  • Seek new credit only as needed. The number of recently opened credit accounts in your credit report, and the number of hard inquiries reported by lenders when you apply for credit, account for 10% of your FICO Score. Lenders see too many new accounts or recent inquiries as indicators of increased risk, so they can hurt your credit scores.

The Bottom Line

While no single credit score can claim the title of “most important,” credit scores in general can be very important to your financial future. Taking steps to improve your credit, and marking your progress by tracking your credit score for free are great ways to prepare for home buying, seeking a car loan or otherwise using credit in pursuit of your dreams.

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A home equity line of credit, or HELOC, is a type of secured loan that gives you access to cash based on the equity in your home. You draw from a HELOC as needed and repay some or all of it monthly, somewhat like a credit card.

When applying for a HELOC, a lender will usually evaluate if you have enough equity in your home—the difference between your home's current value and what you owe on your mortgage—for the amount you want to borrow.

Although a HELOC can be a flexible and often inexpensive way to borrow money, it doesn't come without risks. Take a look at the pros and cons of a HELOC to see if it's a good choice for you.

Pros of a HELOC

A HELOC can be a convenient way to tap into the equity in your home to pay for a large renovation, consolidate debt, cover the cost of college and more. A HELOC also comes with a few other advantages.

Lower Interest Rates Than Unsecured Loans

A HELOC is secured by your home as collateral for the loan. For that reason, lenders typically consider HELOCs less risky than some other types of financing, like unsecured personal loans or high-interest credit cards. As a result, lenders can often offer lower interest rates and initial closing costs. However, because HELOCs are often adjustable-rate loans, your HELOC's interest rates can increase or decrease over time.

Only Borrow What You Need

Unlike a loan where you get one lump sum to be paid back in equal installments, with a HELOC, you can choose to borrow only what you need up to your credit limit. HELOCs typically give you a 10-year "draw period" during which you can borrow money. You'll make low, often interest-only monthly payments during this time.

When the draw period closes, the HELOC must be paid back in full, typically over 20 years. At this time, you can also opt to refinance.

Flexible Repayment Terms

Depending on the lender and how much you borrow, you may have flexibility in terms of how you pay off your HELOC. Some lenders offer a discounted interest rate for a short time, called an introductory rate, which can temporarily make your monthly payments more manageable.

During the draw period, you may only have to make interest payments based on your balance, but you might also be able to pay toward your principal if your lender allows it. Keep in mind that if you make interest-only payments during the draw period and borrow a large amount, say $50,000, you will have much higher monthly payments once the draw period ends and you begin repaying the principal amount.

Cons of a HELOC

Although HELOCs offer many benefits, including lower interest rates than on unsecured loans and flexible repayment terms, there are a few drawbacks.

Risks Your Home as Collateral

With a HELOC, you use your home as collateral for the loan. Anytime you put up collateral, you risk losing it if you cannot make your payments. Because losing your home is a very real possibility if you fall behind on HELOC payments, consider your ability to repay carefully.

Also, if the value of your property falls significantly below the appraised value, or if your lender no longer feels you can make your payments because of a change in your finances, your lender may reduce or freeze your line of credit. Should this happen, you can no longer draw funds from your HELOC.

Interest Rate Is Usually Variable

Most HELOCs come with variable interest rates, which can rise and fall with market rates. Although in some cases a variable-rate loan can be a better option than a fixed-rate loan, especially if interest rates are dropping, a HELOC with a variable interest rate runs the risk of costing you more over time if market rates rise.

Lowers Your Home Equity

When you take out a HELOC, you shrink the equity in your home that you've worked so hard to build up. If the housing market in your area slows, you could end up owing more on your loan than your home is worth, meaning you are underwater on your mortgage. This may also be true if you bought high and property values have fallen significantly since then.

Depending on how much the value of your property has decreased since you purchased your home, you may also have little equity or even negative equity, where the value of your home is less than the original mortgage principal.

Should You Get a HELOC?

Because your home is used as collateral for the HELOC, your lender may be more willing to lend you the money, even if your credit is less than stellar. However, it's common for lenders to want to see a credit score of at least 680 or higher. Although not the only determining factor in getting a HELOC, if your credit is on the low end, having significant equity in your home may tip the scale in your favor.

Since lenders typically let you borrow between 60% and 85% of your property's current appraised value (minus your remaining mortgage balance), a HELOC can be a less expensive option than credit cards or unsecured personal loans, particularly if you're using it for a large expense such as a home remodel.

Keep in mind that closing costs on a HELOC can range from 2% to 5% of the line of credit amount, so factor in that amount when deciding whether a HELOC is right for you. However, some lenders charge no closing costs at all.

Alternatives to a HELOC

When you need an influx of cash to pay for a large expense or consolidate debt, a HELOC isn't your only option. Here are others.

Home Equity Loan

With a home equity loan, you borrow against the equity in your home, just like a HELOC. But home equity loans are installment loans, so you receive the total amount upfront and make fixed monthly payments over the loan's term. Because a home equity loan usually offers a fixed interest rate, your payments are predictable and remain the same over the life of your loan. That can make it easier to budget your month-to-month expenses. Keep in mind that just as your first mortgage is secured by your home, so is a home equity loan—and the same risks apply.

Unsecured Personal Loan

An unsecured personal loan does not require collateral. That's good news since you won't risk losing your home if you can't make your fixed monthly payments. However, anytime you miss payments on a loan or another type of financing, your credit score can take a hit.

Many personal loans have shorter repayment periods than home equity loans and are best if you need to borrow a smaller amount. Because the loan is unsecured, it can be more challenging to get a loan if you have poor credit and you may pay higher interest rates on a personal loan than with a HELOC.

Cash-Out Refinance

If you have substantial equity in your home, a cash-out refinance may be an option. A cash-out refinance is a new, larger loan that pays off the balance on your original mortgage and lets you take what is left over as cash to be used for most any purpose.

The catch? You lose a portion of the equity you've built up, have a larger loan balance, may have to pay closing costs and are not guaranteed a lower interest rate than what you're already paying or that you might pay with a HELOC or home equity loan. However, if you are in a better financial position now than when you took out your first mortgage, you could possibly reduce your loan term and interest rate (lowering your total costs) and still get the cash you need.

The Bottom Line

In certain circumstances, a HELOC can be a good option. HELOCs often come with lower interest rates than unsecured loans and many credit cards, but the rate is variable, meaning it can go up or down. Your house is also used as collateral, providing less risk for lenders but more risk for you if you can't make the monthly payments.

Before applying for a HELOC (or any other type of financing), get your free credit report and credit score to see where you stand. It can often be better to sit tight and work to improve your score before you apply. That way, you get the most competitive terms when you're ready to proceed.

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