How to get a Home Equity Loan with Bad Credit

Original Content Source: Allison Martin & Tracy Yochum (Miami Herald, published August 18, 2024) (https://www.miamiherald.com/banks/mortgage/home-equity-line-of-credit-bad-credit/)

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"You want to get a home equity loan but worry you won’t qualify due to past credit issues. That may not be true, as bad credit isn’t always a deal-breaker. However, a lower credit score could mean less favorable terms on a HELOC if you find a lender that’s willing to work with you.

Keep reading to learn about hurdles you could face when trying to secure a HELOC with bad credit and ways to overcome them.

What is a HELOC?

A HELOC or home equity line of credit is a debt product that allows you to borrow against your home equity. It’s secured by your home and acts as a second mortgage.

How does a HELOC work?

When you apply for a HELOC, the lender orders an appraisal to determine how much your home is worth. This figure, coupled with other financial factors, is used to come up with a loan amount.

Most lenders let you borrow up to 85% of your home equity, or the amount of your home you own outright. To illustrate, if your home is valued at $385,000 and your current mortgage balance is $165,000, you may be eligible for a HELOC of up to $162,250 ($385,000 * .85 – $165,000).

You can borrow up to the credit limit during the draw period, typically 5 to 10 years. During this period, most lenders also require interest-only payments, though you’re free to pay above the minimum each month. Also, keep in mind that the interest rate on HELOCs is generally variable, which equates to fluctuating monthly payments.

When the draw period ends, withdrawals are no longer permitted, and monthly principal and interest payments will commence.

Home Equity Line of Credit and Bad Credit: An Overview

It can be difficult to get a HELOC with bad credit, but it’s not impossible.

Defining Bad Credit

Credit scores range from 300 to 850 – the higher, the better. The FICO Scoring model categorizes any credit score below 601 as bad credit. This means you’ve had past credit challenges, and lenders may be reluctant to extend credit to you. If they do, you’ll likely qualify for less favorable financing terms.

Common Causes of Bad Credit

Many factors can lead to bad credit, starting with late or missed payments, as payment history accounts for the biggest component of your credit score. A high credit utilization rate could also be the culprit, or you could have several hard inquiries in a short period of time that are dragging your credit score down.

Importance of Credit Score in HELOC Approval

Lenders assess your credit score when you apply for a HELOC to gauge your creditworthiness or the likelihood of repaying what you borrow on time. Ideally, you want a strong credit score for better approval odds and more favorable terms.

If it’s lower, you could still get approved. But you may have to do a bit more legwork to find the right lender offering reasonable terms on a HELOC.

Challenges of Getting a HELOC with Bad Credit

Below is a closer look at the hurdles you may face if you have bad credit and apply for a HELOC.

Increased Interest Rates

As previously mentioned, lower credit scores generally mean higher borrowing costs. Lenders want to minimize the risk they incur and do so by extending higher interest rates to credit-challenged borrowers.

Stricter Lender Requirements

More stringent lending guidelines are also common for borrowers with poor credit. You may need to provide more documentation to prove your financial stability. Lenders might ask for detailed income statements, employment history and a list of assets. A co-signer may also be required to secure a loan approval.

Lower Loan Limits

HELOCs are typically capped at 85% of your home equity. However, a bad credit score could limit the amount you’re able to borrow since lenders evaluate your creditworthiness during the application review process.

Time-Consuming Approval Process

It can take some extra time to get approved for a HELOC with bad credit. The lender may take additional steps when reviewing your loan application to ensure you’re a good fit for funding.

Other Risks and Considerations of Getting a HELOC with Bad Credit

Beyond these challenges, there are also risks associated with securing a HELOC with subpar credit.

Risk of Foreclosure

Remember, HELOCs act as second mortgages and use your home as collateral. If you get a less favorable interest rate, expect significant borrowing costs that could make your payment unaffordable. And if you fall behind, you could face foreclosure.

Variable Interest Rates

Variable interest rates fluctuate with market conditions. If you have bad credit, expect to start out with a relatively high interest rate, and understand that it can increase over time, along with your borrowing costs.

Impact on Credit Score

When you apply for a HELOC, the lender runs a hard credit check that could ding your credit score by a few points. Your credit utilization rate is also impacted as you begin to pull funds from your HELOC – high utilization can negatively impact your score. But keeping your utilization low and making timely payments could help your score.

That said, if you miss payments and the account becomes 30 or more days delinquent, your score will also take a hit.

Possible Fees and Penalties

HELOCs often come with several fees and penalties, which can be more burdensome with bad credit. Some lenders may charge higher fees to compensate for the risks assumed by extending credit to credit-challenged borrowers.

The fees you’ll pay vary by lender but generally include application fees, annual maintenance fees and early repayment fees (if applicable).

Strategies to Improve Chances of HELOC Approval with Bad Credit

If time is on your side, focus on improving your credit score to help boost your approval odds.

Improving Your Credit Score

Start by checking your credit report for errors and disputing any inaccuracies. At AnnualCreditReport.com, you can get free copies of your credit reports weekly from the major credit bureaus—Experian, TransUnion and Equifax.

Pay down existing balances, especially on credit cards and personal lines, which are both forms of revolving debt. Making timely payments on all debts, like your mortgage and personal loans, also helps since payment history is the most significant component of your credit score. Setting up automatic payments or reminders ensures you never miss a due date. If you’re behind on payments, work with creditors and lenders to bring these accounts up to date.

Reducing Existing Debt

First, focus on paying off high-interest debts, particularly credit cards. This will help reduce your debt load and improve your credit utilization rate, which could boost your credit score. Once you’ve paid off these balances, shift your focus to high-interest installment loans.

Increasing Home Equity

You could improve your chances of securing a HELOC by increasing the equity you have in your home. Completing minor renovations or improvements can boost your home’s market value. You can also pay down your existing mortgage faster to boost your home equity.

Providing Proof of Stable Income

Lenders want to know that you have a stable income and the ability to make timely home equity loan payments. You can prove that you have the means to cover payments with income documents that demonstrate you are financially stable. It also helps to have at least two years of employment history with the same employer or in the same industry.

Demonstrating Financial Stability

To piggyback off the last point, financial stability is paramount in the eyes of lenders. Having reserves on hand is another major plus for lenders, as it shows you have a buffer to cover unexpected expenses.

Steps to Apply for a HELOC with Bad Credit

If you decide to apply for a HELOC with bad credit, here’s how to move forward with the application process.

Researching Lenders Willing to Work with Bad Credit

Begin by identifying lenders willing to work with individuals who have bad credit. Not all lenders handle HELOCs for those with lower credit scores, so it’s vital to find ones that do.

Check online reviews and ratings to learn about their reputation and customer service quality. Speaking with a mortgage broker is also a good idea, as they can connect you with suitable lenders from their extensive network that you might not have found on your own.

Complying with Required Documentation

Gather and organize the required documentation the lender will need to process your application. Most require proof of income, tax returns, recent pay stubs and information about your current debts. Some lenders may also ask for bank statements and property tax records.

Having these documents handy can help speed up the approval process and get you funded sooner.

Assessing Your Property’s Equity

Evaluate how much equity you have in your property. Lenders generally let you borrow up to 85% of your home’s equity. But the more equity you have, the better your chances of getting approved.

Understanding Loan Terms and Conditions

Be sure to review the loan agreement and familiarize yourself with the terms and conditions. This includes the interest rate, repayment schedule and any other applicable fees.

Some lenders may offer variable interest rates, while others provide fixed rates – the latter is less common. Understand how the interest is calculated and whether there are prepayment penalties. Knowing these details can help you prevent unwanted surprises and unexpected costs later on down the line.

Submitting Your Application

Confirm all sections are completed accurately and honestly. Double-check your documentation and any forms required by the lender to avoid an inadvertent denial.

Some lenders allow online applications, which can be more convenient and take less time to complete. Reach out often to the lender for updates on your application status, and provide any additional information they request promptly to keep the lending process running smoothly.

Conclusion: Balancing Risks and Benefits to Make an Informed Decision

When choosing between a HELOC and other funding options, it’s vital to weigh the benefits against the risks. Traditional loan products offer the advantage of fixed interest rates and predictable monthly payments. Plus, you can improve your credit score by managing them responsibly. However, HELOCs provide more flexibility and the ability to control borrowing costs, as you’ll only pay interest on the funds you withdraw.

That said, you want to run the numbers and confirm the monthly payments work for you before signing on the dotted line to confirm whether a home equity loan makes financial sense or if you should consider other alternatives to secure the funding you need."

Original content source citation for credit: Allison Martin & Tracy Yochum (Miami Herald, published August 18, 2024) (https://www.miamiherald.com/banks/mortgage/home-equity-line-of-credit-bad-credit/)