A borrower’s credit score is one of the most important components of a home equity loan application.
Your credit score reflects your past payment behavior as well as your current total debt burden. So, lenders use credit scores as a way to assess a borrower’s risk level and the probability of default.
A low credit score signals to a lender that you have not been responsible with debt in the past and might not be worth the level of acceptable risk for the financial institution.
Most home equity loan lender’s require a credit score of 620 and anything lower is considered to be bad credit.
Others, however, require a considerably higher credit score in order to be approved for a home equity loan. One of the reasons that a good credit scoreis so important to a home equity loan is that the loan is a second lien against the property.
This is riskier than a first mortgage from the lender’s perspective, because the second lien holder only has a claim to the funds left over from the mortgage lender in the event of a default. So does it mean you’re completely out of luck?
How Does a Home Equity Loan Work?
A home equity loan lets you borrow against the equity position you have in your home. Loan maturities typically vary from 10 to 15 years and the interest rate is usually around 1 percent to 3 percent higher than mortgage interest rates.
A home equity loan is considered to be a secured loan because the home serves as the collateral for the lender in the event of default. Your equity position in the home is the difference between the current market value of the home and the outstanding balance on your mortgage.
The maximum amount of money a lender offers the borrower is related to the amount of equity. Lenders, however, consider the opposite of the equity position, which is the loan-to-value ratio (LTV). The LTV is computed as the total outstanding mortgage balance divided by the current market value of the home.
You can calculate the ratio on your own home by finding the current outstanding balance on your mortgage and dividing it by the most recent appraisal value on your home. Lenders consider mortgages with higher LTV ratios to be riskier. So, your probability of approval is even smaller if you have bad credit and a high LTV ratio.
In general, lenders prefer to see an LTV ratio lower than 80 percent on a home equity loan application. The amount of money you will be able to get with a home equity loan is related to the combined debt burden of your mortgage and home equity loan. The LTV when combining both sources of debt should not exceed 85 percent.
For example, consider a home valued at $100,000 that has a current outstanding mortgage balance of $75,000. The LTV ratio is 75 percent. The maximum amount the borrower can get in a home equity loan is $10,000. The combined debt will equal $85,000, and the LTV will be 85 percent.
How Does Bad Credit Impact Home Equity Loan Approval?
It is difficult for a borrower with bad credit to get approved for a loan because lenders consider the borrower to have a high default risk. Bad credit shows a lender that a borrower has high debt levels or has not promptly made past debt payments. From a lender’s perspective, it is reasonable to expect the same behavior will continue in the future. Borrowers with bad credit are more likely to default on their loans.
Borrowers with bad credit may have more luck getting approved for a home equity loan than they would other forms of debt. A home equity loan has a lower risk for the lender than other types of loans because it is a secured loan. The home acts as collateral for the loan amount.
If the borrower defaults on the loan, the lender should be able to get some of the remaining loan amount by foreclosing on the property. Although home equity loans have a lower level of risk, many lenders still won’t approve borrowers with bad credit.
Importance of Shopping Around for Home Equity Loans
Home equity loan interest rates can vary by lender, so it’s important to shop around for the best interest rate. This is even more important when you have bad credit, because this tends to cause greater variation in interest rates among lenders.
Since the loan interest rate is a measure of loan risk, borrowers with bad credit should expect to pay more than the advertised home equity rates.
Here is an example of how bad credit can increase the cost of borrowing. Consider the previous problem in which a borrower wanted to get a $10,000 home equity loan with a maturity of 10 years.
Borrower with good credit: Credit score of 710 gets a loan with a 6% interest rate. The monthly payments on this loan are $111.
Borrower with bad credit: Credit score of 620 gets a loan with a 12% interest rate. The monthly payments on this loan are $143.
As you can see, over time, the borrower with bad credit will end up paying much more than the borrower with good credit. This is something to keep in mind if you don’t have very good credit.
Repaying Your Home Equity Loan Might Improve Your Bad Credit
Since a high proportion of revolving credit accounts and a history of late payments can lower your credit score, a home equity loan may actually help improve your credit score. It will diversify the types of debt on your credit report, which can increase your credit score. In addition, every month that you make on-time debt payments helps to rebuild your payment history and credit score.