Rising interest rates and persistent inflation have made it difficult for many Americans to keep up with their expenses. As of June 1st, interest rates hovered around 7.08% and inflation was at 4.93%. Both percentages are higher than what most Americans would consider favorable. Luckily for homeowners, they can tap into their home equity through a HELOC, or home equity line of credit.
HELOCs allow homeowners to tap into the equity they’ve accumulated in their properties and use these funds to pay off major expenses. It’s advised to use a HELOC to consolidate high-interest debt, make home renovations, or pay for a child’s college tuition. However, the money can be used for a variety of purposes.
Lenders usually approve HELOCs for consumers with a strong credit history. However, having a lower credit score doesn’t necessarily exclude you from being considered for a HELOC. Here’s what you need to know about obtaining a HELOC with bad credit.
How does a HELOC work?
A home equity line of credit (HELOC) works similarly to a credit card in that it provides the borrower with a revolving line of credit. HELOCs usually include a credit limit and a "draw period," a predetermined time frame during which you can access this line of credit. You can continuously borrow against available funds as long as you stay within your credit limit and pay interest on the HELOC.
Unlike unsecured credit options like credit cards and personal loans, a HELOC is secured by the equity in your home in the same way that home equity loans are. As a result, defaulting on a HELOC puts you at risk of losing your home.
Since your home serves as collateral for the loan, lenders face less risk, enabling them to offer lower interest rates compared to other loan types. This makes a HELOC an attractive financing option for homeowners who want to keep their borrowing costs to a minimum. A HELOC may also come with better repayment terms than other types of financing.
Understanding bad credit
Obtaining a home equity loan with bad credit can be challenging. The same is true for a home equity line of credit. Applying for any kind of financing, including a mortgage, car loan, or credit card, can be difficult with a credit score below 670. A borrower with bad credit may get their financing request approved, but they will likely be approved for a lower credit limit and a higher interest rate.
Lenders use two types of scoring models to assess credit: the FICO score and the VantageScore. Although both systems evaluate credit on a scale from 300 to 850, each model operates slightly differently.
Lenders use a borrower’s FICO score to determine the probability of the borrower repaying a loan. Should your credit score fall within the 300–579 range, it would be classified as poor, potentially causing lenders to perceive you as a high-risk borrower.
In 2022, the average FICO credit score was 714 points. Aiming for a credit score at or above 714 is a good idea. Here’s how the FICO credit scoring system ranks credit scores:
- Poor: 300-579
- Fair: 580-669
- Good: 670-739
- Very Good: 740-799
- Exceptional: 800-850
VantageScore represents an additional credit scoring model that utilizes consumer credit reports to generate credit scores. Within the VantageScore model, a credit score between 300 and 660 is categorized as ‘poor.’
Scores below 500 are classified as ‘very poor.’ The average VantageScore in 2022 was 697, which is well within Vantage’s ‘good’ credit score range. Here’s how the VantageScore model ranks credit scores:
- Very Poor: 300-499
- Poor: 500-600
- Fair: 601-660
- Good: 661-780
- Excellent: 781-850
Factors that impact your credit score
Your credit score is determined by the data contained in your credit report, which is compiled by the three major credit bureaus: Equifax, Experian, and TransUnion. These bureaus create individualized credit reports based on the utilization of different credit accounts under your name. The FICO model considers the following five factors when calculating your credit score:
- Payment history (35 percent): Arguably, the most important factor contributing to your credit score is whether or not you pay back your debt and if you pay it back on time.
- Credit utilization (30 percent): The second most important factor is your debt-to-credit ratio which is the difference between how much you owe and the amount of credit available to you. Lowering your credit utilization ratio helps boost your credit score.
- Credit history (15 percent): Lenders also take into account the length of your credit history, which is essentially how long you’ve been able to successfully maintain healthy credit accounts.
- Credit mix (10 percent): Lenders like to see a mix of credit, meaning you’re not just paying off credit cards, but also car loans, student loans, and other forms of financing.
- Credit applications (10 percent): How often you apply for new lines of credit also impacts your credit score. Borrowers who are constantly applying for new credit may be considered high risk by lenders.
How your credit score impacts a HELOC application
When applying for a HELOC, it's important to keep in mind that each lender sets its own standards for minimum credit scores and other factors. However, FICO scores generally affect your chances of being approved for a HELOC in the following ways:
- 760 and above: Applicants may qualify for credit at the best rates.
- 700 to 759: Applicants are likely to qualify for the credit, but not at the best rates.
- 621 to 699: Applicants may find it difficult to qualify for a HELOC with fair credit and are likely to pay higher rates.
- 620 and below: Applicants are likely to have trouble qualifying for a HELOC with bad credit, regardless of the rates offered.
Can you get a HELOC with a low credit score?
Whether or not you get approved for a HELOC depends on a variety of factors. Your credit score is not the only determinant. Lenders take into account additional considerations such as the amount of equity in your home, loan-to-value ratios, and existing debt levels.
However, a borrower's credit score will heavily influence the interest rate at which a HELOC is approved. Therefore, while you could get approved for the amount you need, it may come at a higher cost due to poor credit. If you have bad credit but want to increase your chances of getting approved for a HELOC, here’s what you need to know:
Have enough home equity
The first thing you should consider is the amount of equity you have accumulated in your home. Equity is the difference between how much your home is worth and how much you owe on your mortgage. You build equity through steady mortgage payments and home appreciation. Borrowers need to own a minimum of 15%-20% equity in their home to get approved for a HELOC. This usually means you will have to have owned the property for a certain amount of time. For most homeowners, it takes about five to ten years to build 15%-20% equity in their homes.
Check your credit report
A minimum credit score of 670 is necessary in order to obtain a HELOC at a reasonable interest rate. As mentioned above, the minimum credit score requirement for a HELOC varies by lender, but your credit score will still impact the rate at which you’re able to borrow. You can check your FICO Score and VantageScore with any of the major bureaus: Experian, Equifax, or TransUnion.
Calculate your DTI
Lenders look at your debt-to-income ratio (DTI) when determining if you can afford to pay back a HELOC. To find out your DTI ratio simply divide your monthly debt payments by your gross monthly income. A maximum debt-to-income ratio of 43% is recommended, although some lenders will accept as high as 50%.
Consider a co-signer
If your credit score is poor or very poor, you may not be able to get approved for a HELOC independently. Instead, you’ll need to bring on a co-signer with a higher credit score. A co-signer is essentially a third party who assumes equal responsibility for the loan with you. It’s best to ask someone close to you, such as an adult child or sibling, to cosign for you.
Applying for a HELOC with bad credit
The documents needed to apply for a HELOC are similar to the documents needed to apply for a mortgage. Lenders are essentially looking to verify your identity, income, assets, and property information. Here are some examples of documentation you’ll need to submit with your HELOC application:
- Your name, date of birth, and Social Security number.
- Your current address (and previous address if applicable, depending on your duration at your current residence).
- Your employer's name and address.
- A duplicate of a government-issued identification with a photo, like a driver's license or state ID card.
Documentation for income and assets:
- Pay stubs from the previous 30 days.
- W-2 forms from the last two years to validate earnings.
- Profit-and-loss statement for the current year (applicable for self-employed individuals).
- Tax returns for the last two years (applicable for self-employed individuals).
- Award letters for disability, Social Security, or pension income (alternative documents such as bank statements or 1099 forms may be accepted as proof for these income types).
- Documentation of retirement account distributions, including award letters, bank statements, or tax forms.
- Alimony and child support documentation, which can include a divorce decree, court order, or bank statements reflecting deposits made to your account.
- Bank account statements for the past two months.
- Investment and retirement account statements for the past two months.
- A copy of your homeowner's insurance declarations page, obtainable from your insurance provider.
- The most recent property tax bill.
- Your latest mortgage statement, reveals the remaining balance and escrowed amounts for homeowners insurance, property taxes, private mortgage insurance, or homeowners association fees.
- A copy of your flood insurance declaration if your property is situated in a flood zone.
Pros and cons of getting a HELOC with bad credit
Taking out a HELOC with bad credit comes with benefits and drawbacks. Here are some things to consider before submitting an application.
- HELOCs usually come with lower APRs than credit cards.
- Borrowers can claim tax-deductible interest on a HELOC.
- HELOCs offer flexible withdrawals and repayment plans.
- If paid back on time and in full, a HELOC could improve credit history.
- Homeowners risk losing their homes if the HELOC is not repaid.
- Home equity is reduced during the time the HELOC is active.
- Interest rates in HELOCs vary and can increase over time.
- If borrowers are not careful, they can quickly run up a large balance.
Alternative financing options
If the drawbacks of taking out a HELOC with poor credit outweigh the benefits for you, consider the following financing options. Beyond HELOCs, you could also take out a home equity loan, a personal loan, new line of credit, or obtain a Home Equity Investment.
Home equity loan
A home equity loan, also referred to as a second mortgage, allows homeowners to borrow money using the equity in their home as collateral. The loan amount is received in a lump sum and repaid through monthly installments. It works similarly to a reverse mortgage or cash-out refinance,
Personal loans allow borrowers to make fixed monthly payments, receive funds in 1-7 days, and pre-qualify without impacting their credit score. This may be a better option for borrowers who don’t want to put their homeownership on the line.
Depending on the amount of money you need to borrow, a credit card may be a more viable option. Although credit cards come with high-interest rates and fees, this kind of financing could make sense for borrowers who don’t need a large loan amount.
Home Equity Investment
Lastly, borrowers should consider a Home Equity Investment (HEI), which allows homeowners with a 500+ credit score to access a lump sum of cash with no restrictions on how the funds can be used, no monthly payments, and no income requirements.
Instead, homeowners repay the investment amount plus a percentage of the home’s future appreciation at some point during a 30-year term. Homeowners pay back the HEI in a lump sum when the house is sold, refinanced, or sometime in the future.
A Home Equity Investment is an attractive financing option for homeowners because it comes with:
- Lump sum payouts
- No monthly payments
- If the home value goes down, the payback amount may be smaller
- No restrictions as to how money is used
- No prepayment penalties
Using a Home Equity Investment as alternative financing
Realizing you can’t take out a HELOC because of bad credit can be disappointing. If taking out a home equity loan, personal loan, or credit card aren't viable financing options, consider a Home Equity Investment. Point provides a unique financing solution to homeowners with low credit scores who need home equity funds deployed efficiently and with maximum flexibility. Visit Point to find out if you qualify to fund your goals without new monthly payments.