Homeowners have an advantage compared to other consumers when it comes to borrowing money in an affordable way. Both home equity loans and home equity lines of credit (HELOCs) can be cost-efficient alternatives to credit cards, personal loans, and other forms of debt given interest rates on these products are comparatively low.
And homeowners who have equity in their homes have the benefit of repaying principal and interest on a home equity loan or line of credit over several years – an option not always possible with other forms of credit.
While these tools are helpful in covering major expenses without touching savings, they differ in terms of how they impact a borrower’s credit profile. Here are a few things to consider when selecting a home equity loan versus a line of credit.
Home Equity Loan
How a Home Equity Loan Appears on Credit Report
A home equity loan is a fixed sum of money provided by a lender that requires fixed payments of principal and interest back to the lender over a period of time. Because of its fixed nature, a home equity loan, often referred to as a second mortgage, shows up on a homeowner’s credit report as an installment debt.
Some lenders report home equity loans as mortgages, given the long repayment period and connection to the homeowner’s property.
Homeowners who opt for a home equity loan see a lesser impact on their credit score when the loan is first funded. This is because credit scoring models calculate loans differently than revolving accounts as there is no credit line to max out.
A home equity loan can drop one’s credit score a few points initially. However, as payments are made on time each month, homeowners are likely to see their credit score creep back up and may even go higher than before.
Home Equity Line of Credit (HELOC)
Unlike home equity loans, home equity lines of credit are revolving accounts. This means that instead of a lump sum, lenders provide a flexible credit line that can be used in any amount up to the credit limit.
Homeowners have more flexibility with home equity lines of credit, as they can borrow as much or as little as they need at any given time. Home equity lines of credit do not have fixed monthly payments, but instead operate similarly to a credit card. Borrowers have a minimum payment due each month but may pay more if they want.
How a HELOC Appears on Credit Report
Home equity lines of credit appear as a revolving debt on credit reports because of the credit limit feature. This can have a negative impact on a homeowner’s credit score more so than a home equity loan.
This is because credit scoring models take into account how much available credit is used at any given time. If a home equity line of credit is near its credit limit, borrowers will see a more substantial drop in their credit scores until the balance is paid down and more available credit is freed up.
Is a Home Equity Loan or Line of Credit Better?
As with most financial options, the answer to the “which is better, a home equity loan or home equity line of credit” question depends on the unique circumstances of the borrower.
When to Choose Home Equity Line of Credit
If there is a need for additional credit in the future, for any reason, having an established home equity line of credit is a smart choice. Instead of going back to the bank or an alternative lender for a new loan, home equity related or otherwise, homeowners can tap into their current home equity line of credit as much or as little as they want or need.
Responsibly using a home equity line of credit also works in favor of one’s credit. However, maxing out the credit line has a negative impact at first.
When to Choose a Home Equity Loan
Alternatively, having a home equity loan is the best choice for those who need a one-time lump sum, without future access to funding. So long as payments are made on-time and as agreed, a homeowner’s credit benefits from a home equity loan. Home equity loans can sometimes come with slightly better interest rates too.
Final Thoughts on Credit Score Impact of a Home Equity Loan or HELOC
Overall, considering your personal financing needs along with your ability to manage repayment over time should help determine whether a home equity loan or home equity line of credit is most appropriate.
