Home equity loans and HELOC loans provide you with cash using the equity you have built up in your home.
Whether you want to consolidate debt or make renovations to your house these refinance programs are a great option.
However, trying to get a home equity loan with bad credit is very difficult.
In this article we will cover home equity loans and HELOC loans. What they are, who qualifies, and alternative options.
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What Is a Home Equity Loan?
A home equity loan is a loan that uses the borrower’s home equity as collateral. It does not replace the first lien mortgage, and instead, it takes a second position.
Generally, you can only borrow up to 75 to 80% of the loan-to-value ratio in your home.
This means that if your current first lien mortgage is at 80 percent of the home value you may not qualify. However, if you only owe 60 percent of the value of your home on your current first lien. You may be able to borrow another 20 percent of the value through a home equity loan.
What is a HELOC?
HELOC stands for home equity line of credit. A HELOC works like a credit card where you have an account where you can withdraw funds from an account on an as needed basis.
One of the benefits of HELOC over a home-equity loan is that you are only charged interest on the money you borrow.
Where as a home equity loan you are given a lump sum of money and charged interest on all of it. You cannot borrow more than the credit limit and will have to repay the loan in monthly installments.
Home Equity Loan / HELOC Pros and Cons
- You can use the funds however you wish.
- The interest rate will typically be lower than you would receive on a credit card.
- An adjustable rate will have even lower rates
- You only pay interest on the cash you borrow.
- Some lenders require a minimum credit score of 620.
- Closing costs and lender fees are involved.
- You will have to use your house as collateral.
- Your line of credit can be cancelled at any time by the bank.
How Much Home Equity You Need
The number one thing you need to qualify for a home equity loan, is equity. Most lenders will allow you to borrow up to 80% of the loan-to-value ratio, or LTV.
For example: If you bought your home for $200,000 and your FHA home loan has a balance of $100,000.
You would be able to get a home equity loan for $60,000. $160,000 is the new total loan amount on the $200,000 property, or loan-to-value ratio of 80%.
There is a minimum loan amount for home equity loans. Typically you will need at least a 30% equity stake in your property receiving 10% of the original loan amount.
The Benefits of Home Equity Loans
In some cases a lender is more lenient on your credit rating when you have collateral that you can tie to the loan, and home equity is an exceptional asset to use as collateral.
This means that even if you do not qualify for an unsecured installment loan at your bank, you may qualify for a home equity loan with bad credit.
This is generally a lower interest rate option as opposed to an unsecured loan, but your credit rating may drive the interest rate higher. In addition, because this is a home loan, you may be able to deduct the interest on your tax return for a financial benefit.
The Disadvantages of using a Home Equity Loan to Pay off Debt
As beneficial as a home equity loan is for those who need extra money and have less-than-perfect credit, there are some disadvantages to consider.
For example, some people will use a home equity loan for debt consolidation.
There is a huge risk turning your home equity into debt just to pay off credit cards off. You will be turning unsecured credit card debt into debt secured by your house.
If you ever default on the payments you risk losing your home.
If you can’t make payments to your creditors there is nothing they can do because the debt is unsecured. You should consider carefully comparing all options before moving forward with the application for a home equity loan.
Home equity loans come with a higher interest rate than alternatives like cash-out refinance loans.
What to Expect When Applying for a Home Equity Loan
Applying for a home equity loan is very similar to applying for a first lien mortgage loan.
If you remember when you applied for your home mortgage when you purchased your home or last refinanced your mortgage, you may remember that this was a long process that required a significant amount of paperwork. Tax returns, pay stubs, bank statements and other documents will be required.
In addition, your lender likely will require you to purchase a new home appraisal up-front if you do not have a recent one available.
You will need to provide the property survey, proof of insurance and title policy for the property. The underwriting process for a home equity loan is similar to that of a first lien mortgage, so you may not receive loan approval and funding for your home equity loan for a month or longer in many cases.
People with bad credit may have a hard time qualifying for a home-equity loan because most lenders require at least 660-680 credit score.
You may have an easier time qualifying for a home equity loan with your credit union vs online lenders. Credit unions are usually based on relationships and are focused on improving their community. If you’ve held an account with a credit union for a long time you’re more likely to get approved.
Home Equity Loan Alternatives for Bad Credit
Home equity loans and HELCO loans are great but if you don’t have good credit history you may not qualify. However, there are some alternative options for borrowers with poor FICO scores.
These options can lower your interest rate, monthly payments, and put money in your pocket.
A cash-out refinance is going to be the closest thing to a home equity loan there is. With a cash-out refinance you can get additional money using the equity in your home.
Unlike a home equity loan which is a second loan on the home, a cash out refinance moves your entire loan balance to a new lender. You can borrow up to 80% LTV.
A cash-out refinance may also be easier to get with a low FICO score than a home-equity loan because the lender retains primary lien rights on your property.
FHA Streamline Refinance
The FHA streamline refinance program is open to everyone with an existing FHA loan. They do not require a credit check, income verification, or an appraisal.
Even if you have bad credit you can refinance your mortgage and save hundreds of dollars a month off your mortgage payments.
VA Streamline Refinance
A VA streamline refinance has the same guidelines as FHA streamline refinances do.
If you currently have a VA loan you can qualify for a streamline refinance to lower your monthly payments.
The Home Affordable Refinance Program is for borrowers that have a Freddie Mac or Fannie Mae backed loan that was made before May 31st 2009.
The majority of loans are Fannie Mae or Freddie Mac, even if your lenders is Chase, Bank of America or Wells Fargo there is a good chance it’s a Freddie or Fannie loan. Even if you are upside down on your mortgage or have little to no equity you can still qualify.
Some lenders do not require a minimum credit score for a refinance through HARP. If you are denied a refinance from a lender, try again. Just because one lender could not work with you doesn’t mean another can’t.
Improve Your Credit Score Before Applying
A bad credit score will not only possibly prevent you from getting approved to refinance your loan, if you are approved it’ll come with a higher interest rate.
Your credit score is directly tied to your credit rating, the higher your FICO score is, the lower your rate will be.
There are a few simple things you can do to increase your credit score before applying for a loan.
- Pay down your credit card balances
- Get added as an authorized user
- Pay off debts
- Remove late payments
Paying down your credit card debt
The balance on your credit cards compared to your credit limit is your credit utilization ratio. And your utilization ratio accounts for 30% of your FICO score.
Only your payment history (35%) has a bigger impact on your credit score. Try to get those balances below 10% of the credit limit to maximize your credit score before having a lender run your credit.
Have a friend or family member add you as an authorized user
An authorized user is a second person listed on a credit card account that is allowed to use the account. When someone adds you as an authorized user on a credit account, the entire account history is reported on your credit report which will raise your credit rating.
Just make sure the account you’re being added to is in good standing and has been open for at least a few years.
Pay off other debts
If you have bad credit and are trying to refinance you’ll want to have as many positive factors on your side.
Paying off debt will help reduce your debt-to-income ratio, making the loan less of a risk to a mortgage lender.
Not only will it make your loan application look more attractive, it may help increase your credit score as well.
Remove late payments
There are a few things you can try to get a late payment removed from your credit profile. First try contacting your creditor and asking them to remove the late payment.
Sometimes a creditor will do this for a long-standing member as an act of goodwill. If that doesn’t work you should dispute it will the Credit Bureaus. Here and more steps to removing a payment from your credit report.
The Bottom Line…
If you have decided to look for a home equity loan with poor credit, it is important that you are aware of your credit scores up-front.
It is recommended that you take this step before shopping for a mortgage.
Lenders generally publish their best rates and terms for those who have excellent credit scores, so you can typically assume that the rate you receive will be higher than the advertised.
When you speak to a lender be upfront about your credit situation. Some may tell you immediately that they cannot work with you. Others will provide you with realistic pricing on your loan based on your credit scores.
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Randall has over 15 years of experience in the mortgage and credit industries. He spends a chunk of time helping consumers understand their credit, advise them on how to increase their credit, and lending his mortgage expertise to help them find the right type of loan. Randall lives in Dallas, Texas with his two sons.