A friend asks you to lend him $100. If you know he has a habit of borrowing money from you and not paying it back, you will probably be hesitant to hand over the cash. Similarly, your mortgage payment history matters when you apply for a home equity loan, says Barry Rothman, a senior housing counselor with the Fort Lauderdale, Florida-based nonprofit Consolidated Credit.
Therefore, if you are thinking of applying for a home equity loan, make sure you understand how your mortgage payment history on your current home and your overall credit history will affect your chances of qualifying and the interest rate deals that lenders will offer you. It is also important to consider how taking on a home equity loan or home equity line of credit (HELOC) will impact your finances, credit reports and credit scores.
How home equity loans and HELOCs work
Home equity financing involves drawing on the difference between your home’s value and what you still owe on the mortgage. Home equity financing generally comes in the form of a revolving line of credit (HELOC) or a second mortgage loan secured by the home.
In order to qualify for a home equity loan, consumers typically need to own more than 20 percent of the home. Lenders usually want you to still have an 80 percent loan-to-value ratio with the home equity loan factored in. Although you can usually borrow up to 85 percent of your home’s equity, the size of a home equity loan can vary depending on factors such as your income, your house’s market value and your credit history.
A standard home equity loan is similar to your original mortgage, and you will make monthly payments on it over a fixed term. A HELOC, on the other hand, functions more like a credit card. You will get a credit limit and only have to pay back what you actually borrow.
Because HELOCs are very flexible and usually have low initiation and annual costs, they can serve as a great source of funding for worthwhile home repairs, according to Joe Parsons, a senior loan officer and founder of the Dublin, California-based mortgage lender PFS Funding.
“Anything that is going to either preserve the value of the home or enhance the value of the home, that’s the kind of thing where a HELOC really makes a lot of sense,” he says.
However, Parsons warns that a line of credit might not be a good idea if you do not have the discipline to stop yourself from using it to fund less important expenses. “For some people, that is a difficult temptation to withstand. They might use it to take a trip. They might use it to do any number of things that, financially, would be ill-advised.”
Why your mortgage payment history matters
Your mortgage payment history and other debt obligations is the single biggest factor influencing your overall credit scores, said Rothman, of Consolidated Credit. Because a mortgage is usually the biggest debt obligation you will have, it can have a huge influence on your creditworthiness and the ability to qualify for a home equity loan or HELOC. For lenders considering your home equity loan application, your mortgage payment history carries a lot of weight.
Banks might have stricter qualification requirements for home equity loans than they do for regular mortgages, because the second mortgage or home equity loan will get paid off after the first mortgage if the borrower defaults on his or her obligations and goes through foreclosure, says Jeremy David Schachter, a mortgage advisor and branch manager with Roseville, California-based Pinnacle Capital Mortgage.
“So payment history is extremely important,” he explains. “Normally they wouldn’t want to see any late mortgage payments for at least for 12 months, but probably for even longer than that.”
Additionally, if you have gone through a short sale or foreclosure, you probably will not qualify for a home equity loan until three to five years have passed.
Home equity financing and your credit
If you qualify, taking on a home equity loan or HELOC will also affect your credit. A home equity loan will show as a tradeline on your credit reports, and because of the new debt, your scores will likely drop a bit when you first get the loan, though not too significantly, Schachter says.
“It’s just like a first mortgage,” he explains. “Sometimes your credit score might drop a little bit because of new obligations you have on your credit report. It shouldn’t drastically reduce your credit score.”
Using a HELOC wisely can boost your credit scores, according to Rothman. If you only use the money when you really need it and pay it back on time, it should improve your credit, just like a responsibly handled credit card, he says.
In fact, if you never use the line of credit, your scores will likely go up because you will increase the amount of credit you have available and subsequently drive down your utilization ratio, which is the portion of your available credit that you are actually using.
“I’ve got all this extra head room,” he says. “That makes me responsible. That’s the kind of borrower that a lender wants to lend money to.”
Ultimately, though, before you can potentially improve your credit by getting a HELOC, you will likely need to show your lender that you are the kind of borrower they like – one with an excellent mortgage payment history.
And remember that a poor mortgage payment history can hurt your chances. “Late payments on a mortgage are an obvious red flag for any underwriter determining whether to approve a home equity loan,” Rothman says.