5 strategies for getting a home equity loan with bad credit
A home equity loan is a worthwhile option if you’re a homeowner in need of a lump sum of cash. These loans feature competitive rates compared to credit cards and personal loans, and you may qualify for a tax deduction. But can you get a home equity loan and reap these benefits if your credit score is bad? It depends.
What is a home equity loan?
A home equity loan is a type of second mortgage. Home equity loans allow you to borrow against the equity you’ve built in your house.
Traditional banks, credit unions, and online companies can all be home equity loan lenders. Most limit the amount you can borrow to 85% of your home equity.
How does a home equity loan work?
To illustrate how a home equity loan works, assume your home is worth $390,000, and you still owe $245,000 on your mortgage. If you qualify for a home equity loan, you could access up to $86,500 in funding.
Why? Because 85% of your home value ($390,000) comes to $331,500. Then, subtract your outstanding mortgage balance ($245,000). The result is $86,500, which is the maximum amount the lender would allow you to borrow. We break it down here:
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$390,000 x 0.85 = $331,500
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$331,500 - $245,000 = $86,500
Lenders disburse funds in a lump sum, payable in equal monthly installments over a term of 5 to 30 years. Home equity loans also come with lower interest rates than many other loan and revolving credit products; those rates are also fixed, which makes monthly budgeting and planning easier. And if you use the funds to buy, build, or substantially improve your primary residence, you may be eligible to deduct the interest paid on the home equity loan on your taxes.
There are, however, some downsides and risks to consider. A home equity loan is a second mortgage that uses your home as collateral. So, if you can’t afford the monthly payments, you could lose your home to foreclosure. You’ll also pay up-front closing costs between 2% and 5% of the loan, and withdrawing funds reduces the amount of home equity you have.
Can you get a home equity loan with bad credit?
A lower credit score isn’t necessarily a deal breaker if there are other compensating factors, such as a low debt-to-income ratio (DTI), high income, or hefty cash reserves, to increase your approval odds.
What is considered bad credit?
FICO categorizes a bad, or “poor,” credit score as any three-digit number below 580. In case you’re interested in a more detailed breakdown, here’s how credit scores are categorized:
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Poor: 300-579
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Fair: 580-669
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Good: 670-739
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Very good: 740-799
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Exceptional: 80- 850
The minimum credit score for home equity loans
Many lenders prefer a minimum credit score of 680 for a home equity loan. However, remember that a “good” credit score isn’t always necessary to qualify for funding. Some home equity loan lenders are more flexible than others and will approve you with a score as low as 620.
That said, if your score falls below this threshold, qualifying will be difficult. If you do find a lender willing to extend you a loan, expect less favorable loan terms, such as a higher interest rate. In this case, you’re probably better off waiting until your score improves to apply unless you get a co-signer.
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5 steps to getting a home equity loan with bad credit
These steps will help you navigate the process with confidence:
1. Understand the lending guidelines
The requirements for home equity loans are similar to those of a first mortgage. Most lenders have guidelines regarding their credit score, combined loan-to-value ratio (CLTV), and DTI ratio limits.
It’s common for lenders to require a maximum DTI ratio of 43% and a CLTV ratio of 85%.
When you’re ready to apply, contact the lenders you’re considering to learn more about what they’re looking for when reviewing applications for home equity loans. That way, you can ask questions, know what to expect, and avoid any surprises.
2. Improve your credit score and debt levels
It’s crucial to look over your credit report, especially if your score is on the lower end. The information on your credit report is used to compute your credit score. So, you want to confirm the report is free of errors that could be dragging your credit score down.
If you do spot inaccuracies, file credit report disputes promptly to have them resolved. You can dispute errors with creditors directly or initiate the process through the credit bureaus by mail, phone, or online.
It’s equally important to avoid opening new credit lines during the application process, because doing so will ding your credit score. And, if possible, pay down your credit cards or other loans to reduce your credit utilization ratio and improve your credit score.
Paying down debts will also improve your DTI ratio, which reflects the percentage of your income allocated to monthly debt obligations. To compute this figure, add up all your mandatory monthly debt payments and divide this figure by your monthly gross (pre-tax) income. Then, multiply the number by 100.
For example, if your minimum monthly debt obligation is $4,500, and you earn $11,000 before taxes, your DTI ratio is 41% — which is below the recommended threshold of 43%.
3. Calculate your home equity
Again, lenders also consider another factor: your combined loan-to-value (CLTV) ratio, which includes the funds from the home equity loan. It should not exceed 85% to qualify for a home equity loan, hence the importance of having enough equity before applying for funding.
Using the example above, if you owe $245,000 on a home valued at $390,000, your LTV ratio would be roughly 63%:
$245,000 / $390,000
If you pull out $80,500, your CLTV ratio would be 83%:
($245,000 + $80,500) / $390,000)
4. Shop around
Don’t settle for the first home equity loan lender you find on Google. Instead, do your homework and inquire with at least three lenders that interest you.
Get prequalified and compare loan quotes to help make an informed decision on which is best for your financial situation. This process is usually quick and doesn’t involve a hard credit check. Keep in mind that the figures you receive from a prequalification are just estimates. You’ll need to apply for mortgage preapproval, which requires a hard credit check, to obtain a more detailed estimate.
5. Apply for funding
Before you formally apply with your chosen lender, organize the documents it will need to process your application, such as employment information and tax records. Doing so can help avoid hiccups in the lending process.
If approved, pay attention to closing costs, prepayment penalties (if applicable), and other fees associated with the loan.
Getting a home equity loan with bad credit FAQs
Should you apply for a home equity loan with bad credit?
It depends on your financial situation. If you’ve exhausted other options, a home equity loan could make sense even if your credit score is low. However, if your credit score is too low to qualify or would result in less favorable loan terms, a personal loan or credit card may be a better fit. Regardless, ensure you can afford the monthly payments on whichever type of loan you take out.
What is the lowest credit score lenders will accept for a home equity loan?
A 620 credit score is typically the lowest that most lenders will go. However, a stronger credit score generally means more competitive rates and lower borrowing costs.
What if your application for a home equity loan is denied?
If a lender denies your home equity loan application, reach out promptly to discuss the denial in greater detail. Doing so gives you an in-depth understanding of what they’re looking for, so you’ll know what areas to improve before applying again. Another option is to reapply with a mortgage co-signer who has a solid credit rating. Be mindful that they will assume responsibility for the home equity loan payments if you fall behind.
Laura Grace Tarpley edited this article.
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