Bad Credit Series: HELOCs and Bad Credit
A home equity line of credit (HELOC) is a popular loan type that lets you borrow the amount that you need against the equity you’ve built up in your home. They’re generally flexible, have decent loan terms, and allow you to spread your borrowing out over time since you’re borrowing in the form of a credit line instead of a lump-sum loan. This gives you more control over how much you borrow and even lets you repay part of the loan before borrowing more to minimize interest charges.
Unfortunately, the terms that you get when taking out a HELOC can be influenced by your credit history and current credit score. This means that getting a HELOC loan with bad credit will be more difficult and will likely cost you more than it would if your credit were spotless. That doesn’t mean it’s impossible, of course. Depending on your situation, taking out a HELOC may be a better option when you have bad credit than some other loans or credit products would be.
Before getting into exactly how HELOCs work when you have less-than-perfect credit, though, it’s important that you understand just what a HELOC actually is.
How Does a HELOC Work?
Unlike some financial products, you can get a pretty good idea of what a HELOC is all about just from its name. A home equity line of credit is, at its most basic, a line of credit that is taken out against the equity in your home. Ok, sure … but what does that mean?
A few things, actually.
Line of Credit
First and foremost, it means that a HELOC isn’t exactly a standard loan. When you think of loans, you likely picture a specific amount of money that you borrow and then repay over time. Sometimes you have to put down collateral, and sometimes it’s just based on your credit history. Regardless of whether you have collateral down or not, you receive your money up front and then make payments until the entire amount has been paid back with interest.
A line of credit works differently. Similar to a credit card, you’re given a borrowing limit with your line of credit but don’t have any actual debt to start with. As you borrow against the line of credit, the amount of your loan goes up and the credit available in your line is reduced.
You can borrow against the credit line over a set period of time (known as the draw period) and can even make payments to reduce your debt and increase the amount available to borrow during this time. Once the draw period ends, your obligation to repay applies only to the amount you’ve borrowed.
Home Equity Basis
When you take out a mortgage, you’re borrowing a large amount of money from a bank or other lender and using the house you purchase as a guarantee that they’ll get their money back. As you make payments on your mortgage, you build equity.
Some people like to think of it as the portion of the home that they “own” compared to what the bank still controls. As you pay more and more against the principal of your loan, your equity goes up and the value of what you’ve paid into your loan increases. Your HELOC is based on this equity, giving you a way to borrow against your home investment even though you haven’t paid the mortgage in full.
A Secured Loan
The fact that the HELOC is based on the equity in your home also means that it’s a secured loan, or a loan that has some collateral in place to guarantee it. Most people think of collateral as some physical object, but it’s simply something with value; in this case, it’s the value of the equity you’ve built over time.
Some other loan types may be secured or unsecured, but HELOCs by their nature are always secured. This means you can usually get better terms than you might otherwise qualify for with an unsecured loan and may also allow you to get a HELOC even when you don’t qualify for similar loans that don’t use collateral.
HELOC Loans with Bad Credit
Even though a HELOC is secured by the equity in your home, your credit history still comes into play when applying for one of these loans. Your credit score will affect the interest rate you pay and may also affect the credit limit on your HELOC. Depending on your lender, a low credit score may also prevent you from getting the most favorable terms—you might be offered questionable options such as “interest-only” payments with a balloon payment at the end or a less-than-ideal draw period to keep you from spreading out your borrowing over time.
With that said, it’s generally easier to get a HELOC loan with bad credit than most other types of loans. You may not be able to unlock all of the value in your equity if you have a low credit score, but if you have enough equity, you should still be able to establish a decent line of credit. As long as you don’t over borrow and you make all of your payments on time, you’ll likely be able to improve your credit score with your HELOC as well.
Improving Your HELOC
If you want to get the most out of your HELOC, it’s important to do a little bit of legwork first. The more effort you put into preparing for your line of credit, the better the terms of your loan will be. Here are just a few of the things that you can do to get ready to borrow:
Pay down your existing debts. Start at least a few months before you plan to apply for a HELOC, but the earlier you start, the more likely it is that your credit rating will be higher when you do apply.
Check your credit report and dispute any listings that seem incorrect or outdated. Even if only a few of the disputed items are removed, it can make a big difference for your credit score.
Contact creditors and see if you can negotiate a deal to bring delinquent items current or pay them off entirely. Some creditors will let you pay off old delinquencies for only a percentage of what you owe.
Make extra payments to your mortgage leading up to your HELOC application. This will increase your overall equity and give you more to secure your line of credit with.
When it comes time to apply, be sure to shop around at different lenders to try and find the best terms and interest rate that you can. Avoid going crazy with your line of credit, restricting it to purchases that you actually need or that will improve your life in some way (like making home improvements, not like buying the LEGO Death Star you always wanted). Be smart with your HELOC and you’ll come out in better shape than you went in … and with better credit to boot.