This article was originally published on Point.com on March 21, 2018.
When it comes to HELOCs and home equity loans, homeowners with bad credit may have concerns. Naturally, they might wonder: can I qualify for minimum requirements? Are these good options for somebody in debt? How do I improve my chances and get lower interest rates? Let’s explore answers to those questions.
What You Need to Know (Short Version)
Minimum Requirements
- For HELOCs and home equity loans, lenders prefer a 700+ FICO score. Anything under 680 will make it quite difficult to qualify. While those are the most common underwriting cutoffs, requirements do vary geographically and from lender to lender.
- Credit scores aren’t the only factor. Your Debt-to-Income (DTI) should be below 45% and Combined Loan-to-Value (CLTV) should be below 80%. Recent delinquencies, foreclosures or bankruptcies also decrease your chances of being approved.
Greater Costs
- With a poor credit score, you’ll almost certainly have a higher interest rate. Since home equity loans and HELOCs use your house as collateral, you are at risk of being foreclosed on if you miss payments, so it’s critical you can handle this extra cost.
Increase Your Odds
- Act to improve your application. Consider bringing on a co-signer (with better credit than you) as a guarantor. Pay off debt to reduce debt-to-income. Or, in some cases, wait until you’ve made more mortgage payments to reduce loan-to-value.
- Find a favorable lender. Ask your existing mortgage provider if they can offer a better rate since you’re already a client. Check with local credit unions who often offer more flexible terms than banks.
Be Mindful of Process
- Discover the lender’s underwriting standards, pricing, and closing fees before filling out any formal applications. Try to close in a short period of time. Lenders pull your credit when you apply. While multiple inquiries are not detrimental to your credit score, applications that take more than a month are harmful.
- Get your documents lined up. Each lender will want statements for all your bank accounts, retirement account, investment accounts, as well as information on all your income. Organize documents digitally with well-organized names, so you can respond to requests quickly. Keep in mind, lenders will want the most recent months of statements.
- Try several lenders, so you can choose the best rate. Be ready for a rigorous process.
Explore Alternative Financing
- New products such as Point may be ideal for homeowners with a FICO score under 700, since underwriting standards are more flexible. Homeowners get a lump sum of money up front, in exchange for future home appreciation. It’s not a loan, so there are no monthly payments.
Getting Started: HELOCs vs Home Equity Loans
Both options use home equity as collateral, but there are key differences. Home equity loans are an up-front lump sum. There’s a fixed interest rate, and you repay with a fixed monthly payment. Timeframes for repayment can vary from 5 to 30 years depending on your specific agreement. In essence, it’s similar to a mortgage.
A HELOC (home equity line of credit) is an account that you borrow from. Borrowers receive a card and/or checkbook. Lenders set a maximum limit. You’re allowed to withdraw up to that amount during a timeframe called a “draw period”. Lines of credit have variable interest rates—the total you pay, as well as each monthly payment, fluctuates based on the market. They may also have tempting starting rates that rise after a few months.
Which one is better? There’s no black or white answer. The choice depends on why you need the funds and reasons for your current poor credit. Let’s look at some example situations.
John is having a hard time with credit card payments. He wants to consolidate that debt at a lower interest rate. In this case, a loan may be more fitting. John can avoid those higher rates with one transaction and immediately focus on improving his credit. With a fixed interest rate, he can worry less about monthly payments unexpectedly rising beyond his ability to pay.
Jane, however, faces a different situation. Her income isn’t the most stable. Soon, she’ll have to start paying her son’s college tuition. Naturally, she is worried about missing those recurring payments, as well as some other big-ticket items. Choosing a line of credit may be an appropriate decision for her. It acts as a financial buffer for her to withdraw from as needed.
Note that these are examples—not rules. Think about the details of your situation.
What Is a “Bad” FICO Score? Can You Qualify?
You have probably heard of your FICO score. It comes from Fair Isaac COrporation (FICO) and is the most popular personal credit scoring system. But what does the number mean? How does it affect your chances of getting approved for home equity products?
FICO scores range from 300 to 850 and, as of July 2017, the average FICO score was just over 700. If your score is below 550, it’s in the bottom 10% of scores today. If your score is below 650, it’s in the bottom 30%. Anything under 700 is among the bottom 43.2%.
Generally, lenders limit HELOCs and home equity loans to borrowers with FICO scores above 700. But if your score is below 700, don’t give up entirely. Some lenders will underwrite credit scores of 680. Just remember that these are only minimums.
Credit scores are also just the starting point. FICO scores are merely signals. Lower scores reflect other attributes of a homeowner’s financial history, and those attributes may also disqualify them from a loan. For example, a bad FICO score may be due to delinquency on loan obligations, carrying high credit card balances, loans being charged off, etc. When underwriters receive an application, they create a composite view of your finances by underwriting across multiple qualification criteria. If you have a lower FICO score, you need some compensating factors that an underwriter can look to when justifying your loan to their credit committee.
Beyond FICO: Other HELOC and Home Equity Loan Requirements
First, there’s Debt-To-Income (DTI). This is the percentage of your gross income already allocated to debt obligations. Generally, your DTI needs to be less than 43% to be approved. Unfortunately, people with poor credit may be predisposed towards a higher DTI. That’s because lower scores are often caused by high revolving debt balances (such as credit card balances being carried month to month). At the end of the day, the underwriter of your loan will calculate the DTI, since credit bureaus don’t have your income information.
Let’s look at an example to understand DTI calculations. John earns $100,000 annually (gross, pre-tax). All his credit card payments, student loans, property taxes, property insurance premiums, mortgages, and alimony payments add up to $60,000 this year. Therefore John’s DTI would be 60% ($60,000 / $100,000). That’s substantially over the 43% maximum, so he probably won’t qualify.
Combined Loan-To-Value (CLTV) is also important. CLTV is the outstanding loan balance(s) secured by the property divided by total home value. Lenders typically don’t lend above 80% CLTV. When calculating, remember that the loan amount is cumulative of all obligations secured by the home—including your first mortgage, any existing HELOCs or home equity loans, PACE loans, etc.
Let’s say Jane Doe’s home is valued at $1,000,000. Her first mortgage still has $300,000 to be paid, and the underwriter is offering her a loan of $150,000. Do the math, and her CLTV will be 45% [($300,000 + $150,000) / $1,000,000].
Your financial history is of utmost interest to underwriters. Among other things, underwriters will look for delinquencies (“DQs”), bankruptcies (“BKs”), or foreclosures (“FCs”). Any “event” (DQs, BKs, FCs) which is not “seasoned” will damage your odds of loan approval. Seasoning occurs after enough time has passed since the event. That’s because, to an underwriter, a bankruptcy from 3 months ago is more relevant than one from 6 years ago. Some lenders might have a shorter seasoning period for bankruptcies and foreclosures, such as of 2 years. But often, it’s much longer. Ask your loan officer for their seasoning rules.
Are HELOCs Worth It with Poor Credit?
You don’t want to accept just any home equity loan or line of credit. You have to decide if terms are worth it first. With a low credit score, homeowners should be especially cautious. Interest rates will be higher, meaning you’ll have to pay more every month in payments. With your home as collateral for the loan, any failure to make those payments can place your house at risk.
Costs and fees will also be written into your contract. Check your loan estimates for fine print detailing closing costs and annual/cancellation fees. Homeowners may also be surprised by unexpected clauses. For example, lines of credit may have immediate withdrawal conditions; loans may have prepayment penalties.
Most importantly, consider the impact of those interest rates again. How much do higher monthly payments hurt your budget?
Improve Your Chances of Qualifying, Get Better Loan Terms
With poor credit, homeowners might struggle to qualify for HELOCs and home equity loans. Even if they get approved, terms will probably be less favorable than they would be for owners with higher scores. But homeowners can be proactive in trying to improve their applications. It’s possible to move the needle by improving your current finances, de-risking the loan for the bank, and finding more favorable lenders.
If possible, pay off as much existing debt as you can. Your loan balances determine up to 30% of your FICO score. So you can both improve your credit score and improve your DTI. Remember to prioritize high-interest credit card balances, since they cost the most. But keep in mind that paying off debt isn’t a silver bullet. It takes time to recover from bad credit scores.
You can also de-risk the loan. Adding a co-signer, for example, can result in better interest rates if they have better credit than you. Banks may require co-signers to live with you or require other proof of a financial relationship. Additionally, if a low Combined Loan-to-Value is the issue, you can wait to apply after paying off more of your mortgage, thus gaining more equity.
Know that lenders aren’t all the same. Talk to your current mortgage lender. Ask if they can be more lenient with underwriting, given your current relationship. You should also contact credit unions. As member-owned organizations, their motivations are more aligned with the interests of individuals and communities. They may also be more in tune with home appreciation in your local area.
Finally, try alternative financing options. They may be better than traditional loans or HELOCs. Point, for example, pays in cash for sharing a percentage of your home’s future appreciation. Borrowers don’t have any monthly payments. Such companies also have flexible underwriting standards better-suited for lower credit scores.
How Should You Apply for a HELOC or Home Equity Loan?
Before you dive into paperwork and applications, survey a few lenders. This outreach can be valuable. Not only do you avoid negative marks to your FICO score triggered by a lengthy application process, but also you test if applying is even worth your time.
Conversations with lenders are only valuable if you can provide a rough estimate of underwriting metrics. So compile your basic financial information. Request credit reports from all three credit bureaus (Equifax, TransUnion, and Experian) since their scores can differ. By law, you’re entitled to one free report every year from each bureau. After getting your FICO scores, do some back-of-napkin calculations. What are your current Debt-to-Income and Cumulative Loan-to-Value figures?
Then pick up the phone. Contact multiple lenders, because their standards will vary. Get in touch with both local banks and online lenders. Give them your rough estimates and be forthcoming about any recent bankruptcies, foreclosures, or delinquencies. Ask if they believe if approval is within reach. Try to thoroughly understand their pricing, standards, and fees.
Then if you think it’s worth it, apply with several lenders to choose the best offer. After making your list of lenders, try to make the application process as quick as possible. The process may last weeks to months. Each lender will pull your credit history. Multiple inquiries isn’t a problem, but if any of those applications lasts more than a month, your FICO score will drop slightly.
That means you’ll want to shorten the process, so prepare your documents well. Get your home appraised. Collect tax returns, proof of income, home insurance, home value estimates, and other financial documents. Organize and label them well. After submitting your documents, be prepared for additional scrutiny. With below-average credit, lenders may need to further confirm details. Finally, after receiving your offers, choose the best one.
Remember that with poor credit, alternative financing may be a better option than HELOCs or home equity loans. So while waiting for lenders, or even before contacting them, consider Point. We approve people within one week and disperse funds within two weeks. There are no monthly payments, since we invest in your home’s future appreciation with cash, instead of giving a loan. Our flexible underwriting standards are also suited for sub-par credit scores. In the worst-case scenario, you’ll have a backup plan. In the best-case scenario, you’ll have a better choice with no monthly payments.
