Can a HELOC (Home Equity Line of Credit) hurt your credit? Under some circumstances, it can.
The reason lies with the revolving nature of a HELOC and FICO's treatment of revolving accounts in their scoring algorithm. Depending on how the HELOC is coded by the lender, they can be devastating to a borrower's credit score.
If a lender codes a HELOC as a mortgage, then there will be no major credit issues from simply having the tradeline. However, if a lender codes the HELOC as a revolving account - and about half of them do - then there is a real risk of credit damage.
Revolving accounts are those whose balances can go up and down as the borrower uses and pays on the account, such as a credit card. A line of credit works in exactly the same way, which is why it is often coded as revolving.
However, how an individual utilizes their revolving credit makes up 30% of their FICO score, even with no late payments. FICO penalizes heavily for utilization above 50%. For those with excellent credit, FICO will start deducting points for utilization above 20%.
When people secure a HELOC, there are two hazards. The first is they secure only as much as they need to serve there purposes and draw the full amount at closing. This results in 100% utilization for that tradeline. The other factor is that the HELOC balances are often large, dwarfing what many people have available on their credit cards. So, the overall utilization is maxed as well.
This can lower a FICO score by 70 points or more - which can make a big difference in the creditworthiness of the borrower.
If you or your clients are contemplating a HELOC do your best to find out how the lender reports the tradeline to the credit bureaus. Also, take out as high a line amount as possible. Then draw as little as possible at any one time. Having low utilization can actually help your FICO score.
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