An equity loan is a type of loan that is received against some asset with equity. In this type of loan, equity is offered as collateral to obtain the amount of the loan.
The asset or equity offered as collateral in this type of loan must have a fair market value above any pending loan payment or mortgage payments in the case of homes. This security allows asset owners to easily obtain loans while allowing lenders to reduce the risks associated with loans.
The most well-known type of equity loan is the home equity loan. The home equity loan is obtained by offering a home with a fair value above any remaining mortgage payments. Home equity loans are generally easier to obtain than other types of loans. This is mainly due to the reduced risks for lenders due to the secured asset. In case of default on payments, lenders can easily recover the loan amount by auctioning the secured asset.
Secured Loans vs Unsecured Loans
There are two main types of loans that are provided to different entities. Secured loans are the type of loans in which there is an underlying asset offered as collateral. This type of loan is more secure for the institutions offering the loan as it allows them control over the asset in case payments are not made instead of the loan.
These loans also offer borrower benefits such as lower interest rates due to the secured asset. Unsecured loans, on the other hand, do not have an underlying asset provided as security.
These loans are harder to obtain as the requirements to obtain them are stricter than secured loans. The risks associated with unsecured loans are generally higher for the provider institutions. If borrowers fail to repay the loan, lenders cannot recover the loan without legal action. Since the risk associated with unsecured loans are higher, the interest rates on secured loans are also higher than secured loans.
Credit rating is the quantification of creditworthiness of an entity. The credit rating of a borrower gives background information about how the borrower has dealt with previous debts.
Any entity can have a credit rating. For example, individuals, businesses, or even states can have credit ratings. When requesting a loan, a borrower’s credit rating is assessed by the institution providing the loan. Different lending institutions will have different credit rating requirements for borrowers.
In the case of equity finance, the credit rating of the borrowers is also assessed. However, the credit rating requirements for equity loans are lower due to the security provided. This is because the security decreases the risk of the loan. Therefore, even borrowers with poor credit ratings can obtain equity loans easily.
While obtaining an equity loan may be easier for borrowers with poor credit ratings, their credit rating still dictates the interest rates and other terms of the loan. For example, a borrower with a lower credit rating will have to pay higher interest rates than borrowers with higher credit ratings.
Obtaining Equity Loan With Poor Credit
The credit rating determines whether or not the borrower will be granted the loan and the terms of the granted loan, such as interest rates. For borrowers with good credit ratings, equity loans may be easier to obtain than for borrowers with poor credit ratings. Borrowers with a poor credit rating must follow a few tips to obtain an equity loan.
Improve Credit Ratings
While borrowers with a poor credit rating may find it difficult to improve their credit rating quickly, ultimately, the borrower’s credit rating is the decisive factor for the equity loan. Even outside of obtaining an equity loan, improving credit ratings can be beneficial for individuals. Borrowers can try to pay any debts they have on time to improve their credit scores.
If there are any inaccuracies in the borrower’s credit reports, they can dispute the inaccuracies to get them removed. There are many reasons why the credit rating of a borrower may be considered poor.
For example, if the borrower has accumulated a lot of debt from different sources, the borrower’s credit rating will be negatively affected. Likewise, any late payments on bills or loans will also adversely affect the credit rating. If borrowers have a poor credit rating, the best way to improve the credit rating is to compensate for past errors by properly taking care of current or future credit obligations.
Improve Debt To Income Ratio
The Debt To Income (DTI) ratio is the ratio of the total debt of an entity to its total income. Apart from considering improving credit ratings, borrowers can also focus on decreasing their Debt To Income ratio.
Lenders use the debt to income ratio of a borrower to determine how much debt the borrower has taken compared to their total income. Lenders look for an ideal debt to the ratio of mid to low 40s. The debt to income ratio can also be improved, like the credit ratings for borrowers.
The debt to income ratio can be improved by decreasing the total debts that a borrower is obligated to pay or increasing their income. The debt to income ratio can help compensate for a poor credit rating as it helps lenders determine whether the borrower can repay the loan or not.
Determine Loan To Value Ratio
The Loan To Value ratio is the ratio of a loan to the value of the asset that is being provided as collateral.
For equity loans, the value is taken as the amount of equity offered as security. For example, for a home equity loan, the loan to value ratio is the ratio of the loan to the equity in the home that the loan is being taken on less any pending amounts payable on the home.
The loan to value ratio of a home is the ratio of the loan that the lenders will provide based on the home’s value. Borrowers should determine the loan to value ratio requirement for the particular lender they want to obtain a loan from.
Once this ratio is determined, borrowers can estimate how much they can expect to receive a loan. The lower the loan to value ratio of a loan, the more willing the lenders will provide the loan.
Adding a Co-Borrower to Application
Another option that borrowers applying for equity loan have is to add a co-borrower to their application.
Co-borrower can be partners, family members, or friends. Usually, co-borrowers are individuals who are trusted by the main borrower and also trust the main borrower. Co-borrowers should be individuals that have a better credit rating than the main borrower. This can significantly increase the chances of approval.
Once a co-borrower is added to the application, the credit ratings of both borrowers are averaged out. If the average credit rating matches the requirements of the lender, the loan is approved. Co-signing a loan application may prove risky for co-borrowers as in case of failure of the main borrower to repay the loan, the co-borrower will be held liable.
Consider Other Lenders
As suggested above, different lenders have different requirements when it comes to credit ratings. If a borrower does not meet the credit rating requirement of a particular lender, they can look for other lenders.
While other lenders will also have some credit rating requirements and have different loan terms, a lender might approve a loan despite a poor credit rating. Borrowers must, however, consider why the lenders are providing them with loans despite their poor credit rating.
The reason should be justifiable by an increased interest rate requirement. However, some lenders may have some other hidden charges or costs that may benefit the lender but adversely affect the borrower. Therefore, borrowers should perform due diligence before choosing a lender.
Consider Other Options
Ultimately, if no other option works out for a borrower, they should start looking for other alternatives to equity loans. Borrowers can obtain other types of secured loans such as cash refinancing, which is similar to a home equity loan as it also requires the home of the borrower to be offered as collateral.
Borrowers can also look for unsecured loans such as personal loans or credit card loans. Borrowers with a poor credit rating can also avail themselves of subprime loans. Subprime loans are loans with a lower loan limit but significantly higher interest rates. Subprime loans are targeted at borrowers with a poor credit rating. However, subprime loans should only be used as a last resort as they are typically highly disadvantageous for borrowers.
The equity loan is the type of loan where an asset with equity is offered as collateral to obtain the loan.
Since equity loans are less risky for the lender, they have a lower credit rating requirement for the borrower. However, borrowers with poor credit scores should follow some tips to increase their chances of qualifying for the loan. These may include improving their credit score, improving their debt to income ratio, determine the loan to value ratio of the loan, adding a cosigner to the loan, considering other lenders, or considering other options altogether.