JANUARY 2004

Home Equity Lines of Credit Can Harm Credit Scores

In her article in a recent Wall Street Journal, Kaja Whitehouse reports some unwelcome consequences arising from homeowners’ affinity for home equity lines of credit (HELOCs). There is no doubt that home equity lines are popular. Interest rates on HELOCs are considerably lower than those charged on most credit cards. While rates on credit cards may reach 18 percent or more, the cost of home equity lines of credit are currently averaging 4.7 percent, according to HSH Associates. In large part, the difference is justified by the fact that credit card debt is usually unsecured, whereas HELOC balances are secured by the borrowers’ home or other property.

However, the author cites a case in which a borrower was using a closed-end home equity loan for a down payment on his home while it was being built. When his home was finally built, he converted his home equity loan into a home equity line of credit. He was both surprised and dismayed to find that his credit score fell from 702 to 642. The drop reflected the fact that he had increased his “debt utilization rate”; that is, the amount of revolving debt that he owed in relation to the total lines of credit that his creditors had made available to him. Essentially, when he had a home equity loan, the drain on his income from principle and interest payments was fixed. But when he switched to a line of credit, he could increase his borrowings at will, up to the maximum permitted under his line of credit, creating greater exposure for his creditors, hence, greater risk.