A home equity loan could be a useful option for accessing money when you’ve previously paid extra onto your mortgage or the value of your home has grown. But could you run into trouble if your credit score isn’t the best?
What is a home equity loan?
A home equity loan is where you apply to borrow money, using a loan that’s secured by the usable equity in your property.
Your equity is the percentage of the property that you own outright, and doesn’t have a mortgage owing on it. Your equity can increase by making principal and interest mortgage repayments (including extra repayments), and also if your property’s value rises over time.
By using your property’s equity as security when you apply to borrow money, you may get to benefit from lower interest rates or fees. You could use a home equity loan to borrow one large lump sum (such as to purchase an investment property), or to access a line of credit that functions similarly to a credit card with a limit based on your equity (such as to pay for an ongoing renovation project).
However, you may only be able to use a limited percentage of your equity to secure a home equity loan, as your current mortgage will likely require you to maintain a Loan to Value Ratio (LVR), typically of 80 per cent.
Imagine taking out a $400,000 loan to purchase a $500,000 property, having paid a $100,000 deposit. After some time, you may have paid another $100,000 off the mortgage principal, leaving $300,000 still owing. At the same time, the property’s value may have increased to $600,000. This would mean you’d have $300,000 in equity available.
However, because your mortgage lender requires you to maintain an 80% LVR, you could find your usable equity by taking 80 per cent of the property’s current value ($480,000) and subtracting the amount still owing on the mortgage ($300,000) to find your usable equity = $180,000.
What is a credit score?
Your credit score is a number that summarises your record of managing money, calculated by credit bureaus using information in your credit history. Borrowers who regularly pay their bills and loan repayments on time are more likely to have good credit scores, while borrowers who have missed payments, defaults, or bankruptcy in their credit history are more likely to have bad credit.
Borrowers with good credit scores are generally more likely to see their loan applications approved, and may get to enjoy other perks such as faster application processing, lower rates and fees, or higher maximum borrowing amounts.
Bad credit borrowers may find it harder to get loan applications approved, and may be limited to smaller loan amounts, or have to pay higher interest rates and fees.
How do credit scores affect home equity loans?
Much like other types of loans, home equity loans can be affected by the credit score of the borrower. Even though the loan is secured by the borrower’s equity, the lender may still be concerned about the borrower running up more debt than they can comfortably afford to repay.
Borrowers with excellent or good credit scores are more likely to be approved for a home equity loan, provided they hold enough equity to secure the loan, and their income, expenses and debt to income ratio are acceptable to the lender.
Borrowers with average or poor credit scores may find it more difficult to get the home equity loan they want. For example, the lender may limit their maximum borrowing amount, or charge higher interest rates or fees.
Bad credit borrowers are the least likely to be able to apply for a home equity loan. Their applications may be declined altogether if the lender believes the default risk is too high.
How can you improve your credit score?
- Pay your bills and loan repayments on time
- Avoid making multiple credit applications over a short period
- Keep credit cards open to build your credit history
- Avoid moving house and/or changing jobs too often
- Check your credit score and correct any mistakes in your credit history