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Obtaining a home equity loan with a lower credit score means you may face higher interest rates, lower lines of credit and less favorable loan terms. It doesn't necessarily mean you won't qualify, or that you won't be able to use your home equity to get your finances back on track. Most borrowers will find that home equity loans will still be significantly cheaper than alternative financing options, and many lenders are willing to be more flexible due to the high quality of the underlying collateral.
- What Are Your Options for Home Equity Financing?
- Can You Qualify for a Home Equity Loan With Bad Credit?
- How to Improve Your Chances of Approval for a Home Equity Loan
- Alternatives to Home Equity Financing
What Are Your Options for Home Equity Financing?
Borrowers looking to obtain home equity financing generally have access to two options: a home equity line of credit, or HELOC, and a home equity loan.
A home equity line of credit (HELOC) is a credit account tied to the equity in your home. During the initial "draw" period, a HELOC functions just like a credit card, allowing you to spend or repay from month to month. Once the draw period ends, you must pay back any outstanding balance within a specified repayment period. Most HELOCs have a 10-year draw period and a 20-year repayment period. Interest rates on HELOCs are usually variable, but some lenders do offer fixed-rate HELOCs.
A home equity loan or second mortgage is a lump-sum loan with repayments that begin immediately. Loan terms usually range from eight years to 30 years, with fixed interest rates and monthly payments. Home equity loan amounts are higher than HELOC credit limits. In a rising rate environment, the variable rates on HELOCs are likely to surpass the fixed rate for home equity loans as time passes. This makes it a good idea to consider the direction of interest rates when deciding between a fixed-rate home equity loan and a variable-rate HELOC.
Besides your credit score and your ability to repay the loan, the most important factor in qualifying for home equity financing will be the amount of equity you have in your home. Most lenders let you cash out your home equity as long as the loan-to-value ratio on your property doesn't exceed 80%, but you may be capped at 70% or lower if you have poor credit or want to borrow against an investment property.
Can You Qualify for a Home Equity Loan With Bad Credit?
Yes, it is possible to qualify for home equity financing with less-than-perfect credit. With your home as collateral for the loan, lenders will usually be flexible when it comes to approval, especially if you have significant equity in the property. Home equity loans and HELOCs are underwritten based on the following criteria.
Debt-to-Income Ratio (DTI)
Your debt-to-income ratio is the amount of debt you have compared to how much you earn. It helps lenders determine your ability to repay loans. Unlike primary or first mortgages, home equity loans don't have preset DTI requirements. While most lenders will seek a DTI ratio of below 40%, lenders are able to determine acceptable ratios for themselves, so there is some variation across the industry.
Loan-to-Value Ratio (LTV)
LTV is the calculation of your home value versus the equity you've put in so far. This usually takes into account the total amount of money you intend to borrow relative to your equity share. For HELOCs, lenders assess your ability repay the entire credit line, whether you draw the entire amount or not. This maximum figure is called the high combined loan to value (HCLTV).
For example, consider a home valued at $400,000 with an existing mortgage balance of $200,000. The LTV ratio in this scenario would be 50% ($200,000/$400,000). If you take out a $100,000 home equity loan, the amount of financing on the property would increase to $300,000 and the LTV would go from 50% to 75%.
However, let's say you want to take out a HELOC instead. Assume that your HELOC has a $120,000 credit line and you want to draw $100,000. In this case, the combined LTV ratio will still be 75%, but the HCLTV will be 80%. Lenders will look at the HCLTV ratio when evaluating your application for HELOCs, which will be tied closely to your home's appraised value.
Credit Score and Credit History
Your credit scores will affect your loan terms, interest rate, and odds of approval. Minimum score requirements for home equity financing start at 620, with some lenders requiring minimum scores between 640 to 680. Lenders look for negative events such as bankruptcies, foreclosures, collections, liens or judgments.
If you've previously declared bankruptcy, lenders will have set waiting periods after your bankruptcy is discharged before they will consider your loan application. Bankruptcy discharge can take three to seven years depending on the lender. If you've previously experienced a short sale or foreclosure, you will usually need to wait at least five years before you're eligible for home equity financing.
How to Improve Your Chance of Approval for a Home Equity Loan
Begin by minimizing your debt-to-income ratio, either by paying down or consolidating your debts. Lenders may be able to exclude debts you're going to pay off with the new loan from their underwriting calculations. It may also be necessary for you to add a co-signer in order to qualify.
Minimize Your LTV
Before requesting a loan amount, be aware of your loan-to-value ratio and ask about the lender's thresholds for the specific loan product. You don't want to take out too much equity and risk overleveraging yourself, as lenders will be less likely to approve your application. Your approved credit line can vary depending on each lender's acceptable LTV threshold, so it's a good idea to shop across multiple mortgage companies.
Fix Errors on Your Credit Report and Avoid Applying for New Credit
Maximize your credit scores before applying for the loan. Obtaining a copy of your credit report will allow you to check for errors and omissions. You'll also need to keep your credit utilization ratios as low as possible (ideally less than 30%) on your installment and revolving debts throughout the loan process. It’s also best to avoid taking on any significant new debts, as this could jeopardize your ability to obtain a loan.
Add a Co-signer
Consider adding a co-signer to help bolster your application if your debt-to-income ratios are close to the lender threshold. Keep in mind, both the income and debts of your co-signer will also be taken into account on your application. A co-signer's credit scores can't be used in place of your own, but lenders can choose to use a blended score or an average to improve your likelihood of approval at their discretion.
Evaluate different types of lenders and loans before applying. There are many options when it comes to equity lending, ranging from banks and credit unions to direct lenders. Each lender creates its own guidelines and products, so it's worthwhile to do your homework in order to qualify for the best possible terms. Some credit unions have been known to be more lenient than banks when it comes to home equity loans, so it makes sense to inquire at as many places as possible.
Alternatives to Home Equity Financing
If you aren't able to qualify for a home equity loan initially, there are other financing options, each with their own benefits and drawbacks:
Cash Out Refinancing may be an option, even if you can't get a home equity loan because you exceed the maximum loan-to-value ratio. You can potentially rework your first mortgage in order to access your equity, but interest rates and fees are generally higher for cash-out transactions. The benefit is that you'll achieve a dual objective of refinancing and cashing out equity with this option. You may even be able to get better terms and lower rates through a specialized VA Cash-Out refinance if you're a veteran or active service member.
Personal Loans are unsecured debts that aren't tied to the equity in your home, so there aren't any loan-to-value considerations to worry about. The interest rates on these loans are higher than mortgage loans, and the credit lines may be smaller (typically $50,000 or less). Most borrowers will find the interest rates on personal loans to be higher than comparable home equity loans, but many personal loans can be found without origination fees.
Credit Cards can be used to finance large purchases, and some may offer initial promotions of 0% interest for purchases and balance transfers. Once the promotional period expires, however, the interest rates will likely skyrocket above other options. These are better used for small purchases that can be paid off quickly. Be careful of falling into a credit card debt trap when using unsecured revolving credit lines.