If you are a homeowner, you have a valuable asset: the equity in your property. But while you may have easily qualified for your original mortgage, you’ll still need to prove your creditworthiness if you want a home equity loan. This means that your credit score is one of the deciding factors between approval and denial.
What is a home equity loan?
As the name suggests, a home equity loan is a loan secured by the equity you have accumulated in your home. With every payment you make on your mortgage, you increase equity, which is the difference between the amount you owe and the value of the home. If your home goes up in value, it also adds to your net worth. Home equity loans are often called second mortgages.
When you apply for a home equity loan, the lender will assess your creditworthiness based on several factors, including:
- Employment history
- Credit score
What is a credit score?
While each of these factors is important, your credit score is perhaps the easiest for lenders to quantify. Most lenders use your FICO score and pull your credit report from at least one of the three major reporting agencies, Equifax, Experian or TransUnion.
Your credit score is calculated based on five elements:
- Your payment history: 35%
- The amount you owe on all accounts: 30%
- Length of your credit history: 15%
- Credit mix, such as retail accounts, car loans, mortgages and credit cards: 10%
- New credit: 10%
Lenders assume that if your credit score is high enough, you are used to paying on time and being responsible for your money.
If your credit score is less than desirable, you can fix it yourself. Some companies offer to “fix” your credit for a fee, but they don’t do anything you can’t do: call creditors, remove erroneous information from your credit reports, etc. Save money and consider ways to improve your credit on your own.
What credit score do you need?
Credit scores are generally categorized into five levels:
- 300-579: Poor
- 580-669: Just
- 670-739: Good
- 740-799: Very good
- 800-850: excellent
Most lenders are looking for a credit score at least in the good range to approve a home equity loan, with a goal of 700. However, the higher your credit score, the lower the interest rate you may qualify for. So being diligent with your financial life can pay dividends when you’re interested in borrowing.
If your credit score is below 700, all is not lost. Some lenders will take a deeper look at your creditworthiness, analyzing other factors, such as your debt-to-equity ratio. If your score is very low, you can take steps to try to raise it before applying for a home equity loan.
How to increase your credit score
The first step to increasing your credit score is to review your credit reports to determine what is causing it to drop. You can access your credit reports from each of the three credit reporting agencies for free once a year via the official website AnnualCreditReport.com. If you find fraudulent accounts or debts that have been paid but not settled, contact the reporting agency to investigate.
Since much of your credit score is based on your payment history, paying your credit cards, car loan, or first mortgage on time can help boost it. If you’re behind on bills, catch up. Having all your checking accounts in good standing shows lenders that you are paying your bills on time and consistently.
Another way to increase your score is to pay off high balance accounts. You decrease your credit utilization ratio by paying them off, which shows that you have more credit available to you and that you are not, for example, maxing out on your credit cards. Another way to reduce your credit usage is to request a line of credit increase. The more space you put between your debt and your credit limit, the better. The ideal credit utilization is less than 30%.
How long does it take to repair your credit score?
There’s no magic bullet for bad credit, but once you start taking steps to improve your score, it can happen over a period of months. Bad marks on your credit report, such as accounts receivable, late payments, or bankruptcies, stay on your report for seven to 10 years.
Does a bad credit score automatically disqualify you for a home equity loan?
Not necessarily. Although a score in the poor range will likely disqualify you, some lenders will consider other factors in addition to your credit score if it is on the lower end of the Good or High scale. However, if you are approved, you probably won’t have as attractive an interest rate as you would with a better score.
If you qualify for your first mortgage, will you qualify for a home equity loan?
Home equity lenders will make their decisions based on your current creditworthiness. So if you’ve continued to maintain a strong credit history since you took out your original mortgage, you might be doing well. However, if you’ve had a more patchy record since then, you might run into trouble.
Good credit opens many doors, especially in the world of credit. If you want to leverage the equity in your home for a cash loan, you’ll need good credit. If you want a better interest rate on this loan, you’ll need excellent credit. Before applying for a home equity loan, pull out your credit reports and see where you stand.