Home Equity Loans and Bad Credit: How and Where to Get One
Your home is likely the largest single purchase you will ever make during your lifetime. It provides a place for you and your family to live, and traditionally it has been thought of as a type of “forced savings plan” that will help you build security for your future.
Lenders offer home equity loans and other financial products to homeowners who want to use the equity in their property for various purposes. As with any type of loan application, your credit score counts when you’re applying for one of these loans. If you have bad credit, it can have an impact on both your approval and the interest rate.
Let’s look at the equity you have built up in your home and credit issues separately.
What Is Home Equity?
Equity is the difference between what you owe on your home and its fair market value. If you paid $250,000 for a house and your down payment was 20 percent of the home’s value ($50,000), you would have had to take out a mortgage for the remaining $200,000. Assuming the home is worth $250,000, you have $50,000 in equity at the time of purchase.
$250,000 (value of the home) - $200,000 (mortgage) = equity $50,000 (which comes from the down payment)
How to Build Equity In Your Home
There are a couple of ways you increase the equity in your home over time.
Pay Down the Principal Amount of the Mortgage
As you pay down the principal amount, you build equity. Put another way, the equity is the part of your home that you actually “own.” While you certainly do own your home, and you have a deed -- and you pay the property taxes to prove it -- if you took out a mortgage to buy your home, the lender has an interest in it until the mortgage is paid off in full.
Fair Market Value Increases
You can increase the value of your home by improving the property through renovations. The value of the property may increase with changes in the market, although there is no guarantee that the value will increase at a particular rate, or increase at all.
Once you have lived in your home for a few years and have built up a significant amount of equity, it becomes a financial tool that you can use to your advantage.
Home Equity Loan Products
Home equity loan products can be structured in a couple of different ways: a home equity loan (HEL) or a home equity line of credit (HELOC). In both instances, you are using the equity you have built up in your home as collateral when you borrow the funds.
Even though they are called “home equity” loan products, you aren’t limited to using the funds on activities that’ll bring additional equity to your home -- although home improvements are one of the common uses for these loans. On approval, you can use the money for any purpose you wish, such as financing a college education, consolidating debt, or starting (or expanding) a business.
HELOCs and HELs
Andrew Weinberg, a partner at licensed mortgage originator firm Silver Fin Capital, explains more about these two products:
“HELOC and HELs are second mortgages. They’re riskier for the lender to take on, so the lender would expect to receive a premium for that risk in the form of higher interest rates and adjustable rates. For HELOCs, the interest rate is always adjustable; it is never fixed. The rate for a HELOC is typically based off the prime rate plus the lender’s ‘margin’ on top of that.”
“You might see a HELOC advertised as prime + 1% or even prime -0.25%. As the prime rate changes (either up or down), the interest rate on the HELOC will fluctuate. You can pay down the HELOC without penalty, and not pay interest on that outstanding amount anymore. And then you have access to those funds when you want or need them, which gives you more flexibility than with a HEL.
“HELoans are closed-end second mortgages,” explains Weinberg. “They usually have a fixed interest rate for some period of time. ‘Closed-end’ means that the loan amount is an agreed-upon amount before closing; each month, you pay interest and some principal.”
You could take out a 15 year home equity loan (or arrange for an even longer term). It might be based a 30-year amortization but the loan could be due in 15 years -- meaning you have to pay off or refinance the mortgage in 15 years, even though your payments were based on a 30-year loan. As a second mortgage, HELs have much higher rates than a typical first mortgage (probably 2-3% more than a first mortgage).
“Second mortgages are usually smaller than the first mortgage. For example, a borrower might have bought a house for $800,000 with a $600,000, 30-year fixed-rate mortgage. A couple of years later, the homeowner decides they want to redo the kitchen and finish the basement. Let’s say the house is now worth $840,000, and the homeowner gets a $75,000 HELOC or HELoan to access the funds to do the work. They are cashing out some of their equity without touching the first mortgage.
“This might be a good option for the borrower who intends to pay the HELOC off in the near future. If you have a good deal on your first mortgage, you may not want to give that up by cashing-out the equity on your home. You can calculate your “blended” interest rate on both loans, and see how that compares to simply refinancing that first mortgage.”
Credit Qualifications for a HEL or a HELOC
The lender has confirmed that you have a certain amount of equity in your home. The lender also needs to look at your ability to repay, which means running a check on your credit score for a home equity loan. According to Weinberg, you will probably need a FICO score of 680 or higher to get approved for a HELOC. If you apply for a conventional loan, the lender would be able to approve you with a lower FICO score.
Your FICO score only tells the lender part of the story when you are applying for a home equity loan product. It doesn’t take into account circumstances surrounding late or missed payments (or worse), such as illness, job loss, or the breakup of a marriage.
Other Requirements Lenders Look for When Approving Applications
The lender also wants reassurance that you will be able to pay back the money you are borrowing. Your debt-to-income ratio will need to be within parameters the lender finds acceptable.
Calculate Your Debt Service Ratio
To calculate this amount, take all of your monthly debt and divide it by your gross monthly income. If the debt-to-income ratio gets too high, money becomes tight and a homeowner will have trouble paying back a loan. Lenders know that once this ratio gets above 43%, it can cause problems for borrowers -- meaning lenders usually won’t approve an application above this level.
Find a Lender Who Will Work with Someone with Bad Credit
There is good news if you happen to be a homeowner with less-than-perfect credit. Each lender has their own criteria when approving applicants for home equity loans. While you may assume that you can get the best deal from the bank you normally deal with since you already have your checking and savings accounts there, this may not necessarily be the case.
Shop Around for Best Rates
Ashley Dull, editor-in-chief from consumer resource site BadCredit.org, says, “If the lender is local and you already have an established relationship, go there, just for the sake of convenience. This makes it easy to speak face-to-face with someone about your options, but it certainly shouldn't be your only stop.
“As with any financial product, you should always shop around for the best rates. Just because your home bank might be in your backyard it doesn't mean they always have your back. You may be able to find promotional incentives elsewhere and the internet makes it super easy to compare rates quickly; there's really no excuse not to rate shop. You can literally save thousands of dollars by finding an interest rate even a half-percent lower when dealing with a HELOC.”
This is great advice. Consumers are used to shopping around to get the best price on other products and services they use every day; why should financial products be treated differently?
Consider Working with Alternative Lenders
Traditional banks aren’t the only game in town when you are looking to borrow money for a home equity loan. Alternative (private) lenders may also be an option for you. As Dull points out,
“The thing about alternative lenders is that they typically use alternative credit data sources to determine creditworthiness, which specifically benefits people with poor or limited credit. What this means is that they're looking at more than just your credit report and score to base their lending decisions.
“Examples of alternative credit data sources include utility bills, rent payments, and even your education and career trajectory to look at your potential more than just your past. If you're someone who, for example, let a phone bill go to collections several years ago and it's negatively affecting your credit today, a private lender may be more willing to overlook small mistakes in your past more so than a traditional bank.”
You can go online to search for alternative lenders you may be interested in approaching for help when you are looking for a home equity loan product. Before you approach any lender, you may want to do some work to improve the likelihood of getting approved for the funds you need.
Set Yourself up for Success Before Applying for a Home Equity Loan
There are some steps you can take to set yourself up for success before you apply for a home equity loan product. By doing some homework in advance, you can increase the likelihood that your application will be approved and at the best interest rate for your situation.
Money Issues Are Common
Mike Chadwick, the President and Founder of Chadwick Financial Advisors, points out that many homeowners are in the situation of having equity in their home but poor credit. It’s not uncommon for people to be in this situation and feeling the pain that goes along with it.
Get Rid of “Checkbook Syndrome”
He says that many families fall into what he calls “Checkbook Syndrome,” meaning they spend whatever comes in the door. This syndrome is just as common among people with lower incomes as families with higher incomes.
Chadwick explains that the media continually sells consumerism and that people don’t buy things outright; instead, they put items on credit. This turns into a problem when the consumer doesn’t finish paying for the first item before buying more things, and the situation snowballs into further debt.
He recommends getting responsible with money. Make paying bills on time a priority. Be proactive about cutting back on unnecessary spending.
Order a Copy of your Credit Report to Look for Errors
There are three credit reporting agencies (Equifax, Experian, and TransUnion). You can get a free copy of your credit report from each of them once every 12 months, either at the same time or at different intervals. Order a copy of your credit report and go over it carefully, looking for any errors. If you find anything that isn’t accurate, send a dispute letter to the credit reporting agency.
Taking these steps can help you to improve your credit rating before you get in front of a lender. If you have some lead time before you need to access the funds, make the most of them to show the lender a pattern of regular bill payments, paying down your debt, and cleaning up any credit issues.
Alternatives to Home Equity Loans
Home equity loans may not be the right choice for all borrowers, and there are other options available.
Financial debt attorney Leslie H. Tayne, Esq., suggests first considering what you need the money for:
“If you need funds to pay off credit card debt, then you may want to consider a program to reduce debt using your current monthly funds. If capital is needed for a business then it may be best to consider a small business loan. Beyond that purpose, finding the right alternative option is also dependent on the amount you need to borrow, which is something else you should consider.”
Get Access to Cash in the Meantime
If you need to access funds quickly, Dull has some thoughts:
“This depends on a few things: your credit, just how quickly you need the money, and how much money you need. If you need a couple thousand dollars next week, a credit card with a 0% intro-APR is my top recommendation, but only people with good to excellent credit will qualify. This type of credit card allows new cardholders to make purchases for a set amount of time (usually up to 12 months) interest-free.
“But if you can't wait until next week, there are personal lenders — alternative lenders included — who can advance you the funds in as soon as one business day, and the credit requirements tend to be less stringent. With any type of loan product, always be sure to read the rates and terms carefully so you're not hit with any hidden fees or surprise costs you weren't expecting.”
If you still have any lingering questions about your home equity and how you can access it, feel free to reach out to the experts at home.loans today for a free consultation!