Home equity finance is a great way for property owners to turn the unencumbered value of their home into cash. For homeowners with bad credit, these particular loans provide a way to borrow money that is more likely to get approved and offers lower interest rates than traditional loans or revolving credit lines. Why? First, the home serves as the security, or collateral, and second, equity in the property may make up for the shortfall in your credit history. This is especially true for homeowners who have a large amount of equity in their home.
The downside is that you can expect to attract less favorable terms on your home equity financing, and the financing will come at a higher cost. Two examples: you may be forced to borrow a lower amount to minimize risk to the lender, and more collateral (greater equity) may be required to secure it. Lenders typically lend up to 80% of a home’s equity value. However, the more equity you’ve established, the more appealing your application will be. Given that your home is being used as collateral, you will be viewed as a lower-risk candidate if you own 20% or more of your home. This can be particularly helpful when you have a poor credit score. Here is what you need to know to secure the financing you need.
There are two main types of home equity finance. The first is a home-equity loan, whereby a single lump sum is borrowed and repaid in regular installments, typically with a fixed interest rate over a period of 25 to 30 years. The second is a home equity line of credit (HELOC), where the lender authorizes the borrower to withdraw money as needed. Most HELOCs have an adjustable rate, interest-only payments and a 10-year “draw” period, during which the borrower can access the funds. After the draw period ends, the outstanding balance must be repaid over a repayment period (typically 15 years). (For additional insights, read Home-Equity Loan vs. HELOC: The Difference and Choosing a Home-Equity Loan or Line of Credit.)
Here are the steps you need to take to secure a home-equity loan or HELOC.
1. Study your credit report.
Get a copy of your credit report so you know exactly what you’re up against. (You’re entitled to a free one every year from credit reporting agencies: Experian, TransUnion and Equifax.) Check the report thoroughly to ensure there are no inaccuracies that are causing more harm to your score (you should do this routinely). (For more, see Check Your Credit Report.)
2. Prepare your financials.
Gather your financial information (such as proof of income and investments), so it’s ready to present to lending institutions. They’ll want to see in black and white that you’re financially stable enough to support your loan – especially if you’ve got bad credit. If possible, pay off any outstanding debt that could adversely impact your application.
3. Compare rates.
It’s logical to head straight to your existing lender for home equity finance – and given that you’re already a client, the lender may offer a more appealing rate. However, this isn’t guaranteed, particularly in the event that you have a bad credit report. The best rates are offered to those with good credit, so it always makes sense to shop around, particularly when poor credit is involved. Experts say it’s a good idea to work with a mortgage broker who can help you evaluate your choices and guide you to reputable lenders.
4. Consider how much cash you (really) need.
What is the purpose for which you are borrowing? And how much do you really need to borrow? It can be tempting to shoot for the stars to maximize your loan amount, perhaps to provide a financial cushion, but this comes with the temptation to spend it. If your spending habits are under control, it can make sense to “borrow up,” and by using a HELOC, you’re only paying interest on funds as they’re spent. However, in the case of a home-equity loan, you’ll be paying full interest (and principal) on the entire loan lump sum, in which case it probably pays to borrow specifically for your needs.
5. Don’t dive in.
Don’t say “yes” to the first offer. By obtaining multiple quotes, you’ll be in a better position to negotiate a better rate. Present your first offer to another lending institution and see if it will beat it, and don’t forget to investigate all associated borrowing fees (such as processing and closing costs), so you don't get any rude surprises.
6. Bring in a co-signer.
To sweeten the deal, it may be a good idea to bring in a co-signer. A co-signer uses his or her credit history and income to serve as a guarantor for the loan. Be sure to choose a co-signer with impressive credit, good job stability and considerable income to maximize your chance of approval.
7. Look at subprime loans.
As a last resort, you can turn to lenders offering subprime loans, which are easier to qualify for and targeted to poor-credit borrowers who don’t meet traditional lending requirements. Subprime lenders typically offer lower loan limits and higher rates of interest. However, these loans come with much greater risk and higher fees than conventional fixed rate loans and should be avoided if possible.
8. Work on your credit.
If you find that your poor credit history is really working against you, ask your lender why it's not cooperating and what it would like to see from you (and your credit report) in order to provide a better rate. Remember, it's never too late to turn your credit score around. You might consider placing your borrowing plans on hold while you implement steps to improve your rating. Mortgage lenders typically look at the dollar amount, payment history and “age” of your credit lines. Do you frequently open new accounts, miss payments and run up balances? Just changing one of these behaviors can positively affect your credit score. For more, see 10 Ways to Improve Your Credit Report and How can I improve my credit score?
A home-equity loan stretches mortgage debt on the property, which can leave a borrower in a vulnerable position (and unable to keep up with monthly repayments) should financial, income or employment circumstances suddenly change. Perhaps the biggest drawback associated with equity finance is that the bank could foreclose on your property if your ability to make repayments becomes compromised. And you may get hit with hefty late payment fees in the event that you fall behind. This jeopardizes your credit reputation even more, as banks will report your delinquency to credit reporting agencies.
Are you a homeowner with bad credit? You can still leverage the value in your home to obtain cash, but you may not enjoy as much borrowing freedom as someone with a squeaky-clean credit record. Despite the “instant cash” appeal of home equity finance, the decision to obtain it shouldn’t come lightly. It is, after all, more debt – and there are predator lenders ready to take advantage of people with less-than-stellar credit. Compare rates and deals at multiple lending institutions, and even consider engaging a reputable mortgage broker to connect you with viable options.