You’ve probably heard that maintaining an excellent credit score is very important when it comes to getting a mortgage.
Not only will it help ensure you qualify for a mortgage, a tip-top score will also make you eligible for the lowest mortgage rates available.
Yes, you’ll need to document income, assets, and employment as well, but your credit score can have the biggest impact on pricing.
The same is true for HELOC rates, which are tied to the prime rate (currently 6.25%) and a credit risk-based margin.
The margin you receive is heavily impacted by credit score. So if you plan to apply for a HELOC, better make sure your FICO scores are as high as can be.
How the Lender Determines Your HELOC Rate
I was looking at a rate sheet the other day for home equity lines of credit. Similar to rate sheets for closed-end first mortgages, there are pricing adjustments.
But because HELOCs are tied to the prime rate, which is essentially controlled by the Fed, individual banks provide varying margins to come up with your fully-indexed rate.
The margin is the risk-based piece of the equation that relates to your default risk.
In short, the prime rate plus your margin equals your HELOC rate. For example, if your margin were 1% and prime were 6.25%, your rate would be 7.25%.
If and when the Fed lowers or raises the fed funds rate, the prime rate will follow suit by the same amount.
Since early 2022, we have seen the prime rate rise from 3.25% to 6.25% as the Fed continues to fight historic inflation.
This means HELOC holders have seen their interest rates nearly double over the past year.
And they’re expected to keep rising to as high as 7.75% by early 2023. That would mean a rate of 8.75% for our hypothetical borrower with a 1% margin.
Your HELOC Margin Is All You Can Control
| CLTV FICO |
<= 65 | > 65-70 | > 70-75 | > 75-80 | > 80-85 |
| 780+ | 1% | 1% | 1% | 1.5% | 2.5% |
| 760-779 | 1.25% | 1.5% | 1.5% | 1.75% | 3% |
| 740-759 | 2% | 2.25% | 2.25% | 2.5% | 3.75% |
| 720-739 | 2.25% | 2.5% | 2.5% | 3% | 4.25% |
| 700-719 | 2.75% | 3% | 3.25% | 3.25% | 4.5% |
| 680-699 | 4.5% | 5% | 5.5% | 6% | n/a |
As noted, the Fed essentially determines the prime rate via its own borrowing rate because banks set it based on the target level of the federal funds rate.
Technically, banks could choose any prime rate, but they basically just follow the Fed.
This means there’s nothing we can do to change the prime rate, which is what banks tend to use as a base rate for the many loans they offer.
By base rate, I mean prime + some margin based on type of loan, collateral, borrower characteristics, market conditions, and so on.
Typically, you’ll see this in your credit card agreements as well. Prime + X is your interest rate. It’s used for most variable rate consumer loans.
Anyway, instead of worrying about the prime rate, you need to focus on that other component, the margin.
This is what you can control as a borrower, to some extent. Going back to that HELOC rate sheet, FICO score is one of the biggest pricing adjustments.
For example, a borrower who wants a HELOC for 80% of their property value will be hit with a pricing adjustment of 1.5%, assuming their FICO score is 780+.
But what if that same borrower had a FICO score of just 720? They’re now looking at an adjustment of 3%!
Using the prime rate of 6.25% as our base, we’re talking about a HELOC rate of 7.75% versus 9.25%. Simply because of credit score.
If your credit score is below 700, it gets even worse, we’re talking a HELOC rate in the double-digits in all likelihood.
A Low Credit Score Will Also Limit How Much You Can Borrow via Your HELOC
Additionally, those with credit scores below certain levels won’t be able to borrow as much, as their combined loan-to-value (CLTV) will be limited.
So interest rate aside, you might not even be able to tap the home equity you’re interested in tapping. You might be capped at 80% CLTV instead of 90%.
As you can see in the chart above, a borrower with a credit score between 680-699 can only borrow up to 80% of their home’s value.
And a borrower with a credit score below 680 isn’t even eligible for a HELOC at our hypothetical bank.
At the same time, your max loan amount or draw amount could be limited as well. This means paying more and getting less.
Long story short, credit score can be more even more impactful for HELOCs and home equity loans than it is for first mortgages.
For a fixed-rate home equity loan, you might be looking at a rate of 8% for a top FICO score vs. 8.75% to 10%+ if your FICO score is just good or simply average.
If you’re considering opening a HELOC, check your credit scores ASAP and make sure they’re as high as possible before you apply.
