A home equity loan is a type of loan in which a homeowner uses the equity that he has built up in his house as collateral. Generally, a homeowner will be able to take out a home equity loan after he has paid off part of his mortgage or the house has appreciated in value, creating more equity. Taking on additional debt can cause a homeowner's credit score to drop, as can applying for credit.
Applying for a Loan
When you apply for a home equity loan, the lender to whom you apply will often usually choose to examine your credit report to get an idea of your creditworthiness and to determine the terms of the loan he will offer you. When a lender checks your credit report after you've applied to him for credit, this check will cause your score to drop a few points, as credit reporting agencies observe that you may be preparing to take on more debt.
Taking Out a New Loan
One of the main variables that go into a person's credit score is the amount of outstanding debt that the person currently has. Generally, people with larger amounts of outstanding debt, particularly people with shorter credit histories, may see their score drop when they take out new loans, such as home equity loans. This is because taking out more debt causes credit reporting agencies to become concerned that you are financially stretched and preparing to default on one or more of your loans.
Repaying the Loan
The single biggest factor that will affect your credit score is not your taking out of the loan, but how you pay it off. If you miss a payment on a home equity loan, you will certainly see your score drop. However, if you pay off the entire loan on time, your score will likely improve, as credit reporting agencies observe that you are capable of paying off relatively large loans in full, making you a better credit risk.
Fixed-Rate Loans
Home equity loans comes in two main types: fixed and variable. Under a fixed rate loan, the rate of interest that the borrower pays will remain constant for the whole loan. Under a variable rate loan, the rate of interest will constantly vary, usually according to the movements of market rates. Although credit reports recognize no difference between the two types of loans, fixed-rate loans are more stable: a borrower paying off interest at a fixed rate may have less chance of defaulting, as he will not be hit with an unexpected and potentially unaffordable spike in interest rates.
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