If you're facing a big home improvement expense, such as remodeling your kitchen or paying for college tuition, a home equity loan can be a good solution. You can also use a home equity loan for debt consolidation and pay off all your credit card debt in one swoop with the amount of money that makes up your loan amount. Home equity loans give property owners a way to turn the equity in their house into cash.
While homeowners with good credit scores will get the best rates, lenders will also offer home equity loans to those with lower FICO scores because they can lower their risks by using the equity in your house as collateral.
Here's how home equity loans work and how even borrowers with bad credit can qualify.
What Is a Home Equity Loan?
A home equity loan is a loan that is secured by the equity in your house. Your home’s equity is the difference between the market value of your home and the principal balance remaining on your first mortgage.
For example, if your home has a market value of $300,000 and the balance remaining on your first mortgage is $210,000, then your home has equity of $90,000 ($300,0000 less $210,000).
Lenders for home equity loans prefer to keep the total debt on a house under 85 percent of its market value. In our example, the maximum loans could total no more than $255,000 ($300,000 times 85 percent). This means you could borrow up to $45,000 in a home equity loan ($255,000 less $210,000) and remain under the 85 percent maximum.
Home equity loans are disbursed in one lump sum and are repaid in fixed monthly amounts at a fixed interest rate over a specified number of years, like five to 20 years. Home equity loans usually have lower interest rates than personal loans or credit cards because they are secured by the equity in your house, whereas the other types of credit are unsecured.
Read More: How Does a Home Equity Loan Work?
What Is a Home Equity Line of Credit?
Similar to a home equity loan, a home equity line of credit (HELOC) is also secured by the equity in your house. However, the loan is structured differently.
A HELOC is like one of your credit cards. It has a maximum line of credit that you can borrow on a revolving basis. You can borrow the amount you need, pay it back and then borrow it again. You can make several withdrawals during the HELOC’s “drawdown” period, which usually lasts five to 10 years. During that time, you make interest-only payments on the actual amount borrowed. Most HELOCs have adjustable interest rates, so your interest payments will vary during the drawdown period, unlike a home equity loan which has fixed payments after the funds are disbursed.
After the draw period ends for a HELOC, the lender will require you to pay the balance out over a period ranging from five to 10 years.
HELOCs are useful when you don't need all the funds upfront, but intend to withdraw different amounts at various times.
Read More: What is Home Equity?
What Credit Score is Needed for a Home Equity Loan?
For a home equity loan, most lenders will require you to have a FICO score of at least 700 to qualify for the best terms. You can also likely qualify for a home equity loan or HELOC if you have a score less than 700, but the lender will charge higher interest rates and may impose other qualifying factors.
What if You Have a Low Credit Score?
If your credit score is under 700, a lender will look more closely at your debt-to-income ratio and the equity in your house to evaluate your creditworthiness.
The debt-to-income ratio is the total of your monthly loan payments divided by your gross income. Suppose you had a monthly gross income of $5,265 and the following monthly loan payments: a mortgage for $1,250, a car payment of $260 and minimum credit card payments of $175. Your total loan payments add up to $1,685.
Therefore, your debt-to-income ratio would be 32 percent ($1,685 divided by $5,265). Lenders like to see a DTI ratio of less than 40 percent.
The other factor is the equity in your house. Suppose your house has an appraised value of $355,000 and an outstanding mortgage balance of $250,000. Your equity would be $105,000 with a loan-to-value ratio of 70 percent ($250,000 divided by $355,000).
In this situation, a lender would look more favorably at your lower DTI ratio and the amount of equity in your house, even if you have a low credit score.
Read More: What Happens When You Default on a Home Equity Loan?
How to Improve Your Credit Score
Raising your credit score will get you better terms and save you money. Here are the steps you can take to improve your credit score:
Pay on time - Your payment history makes up 35 percent of your credit score. If you have any past-due balances, get them caught up and make all future payments on time. Even if you have late payments in your credit history, your new on-time payments will begin to outweigh the previous negative reports over time.
Reduce balances on your credit cards - The goal is to get your credit card utilization down to 30 percent or less. This means if you have credit card lines totaling $10,000, you want to keep your debt to $3,000 or less.
Keep old credit cards open - Part of your credit score is the length of time you have had credit cards open, even if you don’t use them. The longer, the better. In addition, if you're not using these old credit cards, the overall percentage utilization of all your credit cards will go down, which will boost your credit score.
Don't open new accounts - Each application for a new credit card creates a hard inquiry on your credit report. Each hard inquiry will drop your score by a few points. Making multiple applications will have longer-term negative effects on your score. Furthermore, opening a new account will reduce the average age of your credit history, which will have a negative effect on your score.
Advantages and Disadvantages of Home Equity Loans
The primary advantage of home equity loans is that they have lower interest rates than personal loans and credit cards. In fact, many borrowers use home equity loans to pay off their credit card debts.
On the other hand, a primary disadvantage of a home equity loan is that you are increasing the debt on your home, which adds to your financial risks. For example, if you were to lose your job or incur unexpected medical bills, you might have difficulty making your monthly payments on time. If that happened, you might default on your loans, and you could face foreclosure by the lender.
This means that before you take on the additional payment for a home equity loan, you should consider carefully your financial situation. Do you have sufficient cash flow to make the loan payments in the event of a loss of income? Are you comfortable risking the equity in your home? Or would it make more sense to do a cash-out refinance of your first mortgage?
Home equity loans are an effective way to manage large expenses as long as they are kept in proportion to your financial resources you are aware of the importance of timely repayment.
- Experian: What Credit Score Do I Need to Get a Home Equity Loan?
- LendingTree: Home Equity Loan Requirements in 2021
- Bankrate: How to Get a HHome Equity Loan With Bad Credit
- Federal Trade Commission: Home Equity Loans and Credit Lines
- ConsumerAffairs: Home Equity Loan Requirements
- Zillow: All About Home Equity Loans
James Woodruff has been a management consultant to more than 1,000 small businesses. As a senior management consultant and owner, he used his technical expertise to conduct an analysis of a company's operational, financial and business management issues. James has been writing business and finance related topics for work.chron, bizfluent.com, smallbusiness.chron.com and e-commerce websites since 2007. He graduated from Georgia Tech with a Bachelor of Mechanical Engineering and received an MBA from Columbia University.