At a Glance
It can be tough to get any type of loan when you have bad credit. With a home equity loan, your score doesn’t need to be perfect. Like other loans, there’s plenty to consider when applying for a home equity loan.
In this article, you’ll learn:
- The pros and cons of a home equity loan with bad credit
- Home equity loan vs. HELOC
- Check your debt-to-income ratio
- Calculate how much home equity you have
- What credit score will you need to qualify for a home equity loan?
- Where to shop for a home equity loan if you have bad credit
- Alternatives to home equity loans if you have bad credit
- Try to boost your credit
The Pros and Cons of a Home Equity Loan with Bad Credit
A home equity loan is a secured loan that allows you to receive a lump sum of cash upfront, with your house as collateral. You’re borrowing against the value of your home and the equity you’ve built up in it. Equity is the value of your home, or any asset, subtracted from the amount still owed on your mortgage.
- Interest payments may be tax deductible if money is used for home improvements
- Fixed interest rates and consistent monthly payments
- Easy to predict and budget for
- Can be used for debt consolidation
- More affordable than private loans
- Puts your home at risk as collateral
- May not net as much if you sell your home because you still have to pay the balance of the loan
- Interest rate and total payment will be higher with bad credit
- Long-term fixed rate debt payment
- Two mortgages instead of one
Home Equity Loan vs. HELOC
Because you’re borrowing against the value of your property, a home equity loan can be easier to get for those with bad credit.
Instead of receiving a lump sum as you would with a home equity loan, HELOCs-or home equity lines of credit-function more like credit cards. You can borrow up to a specific limit of your home equity and repay the debt over time.
Check Your Debt-to-Income Ratio
Your debt-to-income ratio, or DTI, is what you owe (your debt) divided by what you make (your income). Lenders typically look for a DTI in the low 40s or less, but some will go as high as 50%.
A higher DTI is a turnoff for lenders because it means you have less to put toward a potential home equity loan. Ultimately, it’s a balancing act between your credit score and your DTI, but if you have a lower credit score, it’s helpful to have a lower DTI.
Calculate How Much Home Equity You Have
With a home equity loan, you can typically borrow up to 85% of your home’s value.1 The most you can borrow is based on your loan-to-value ratio, also known as LTV. To calculate your LTV, divide the amount you still owe on your loan by the current value of your home.
For example, if your home is appraised at $250,000 and you still owe $175,000, your LTV is 70%. If a lender lets you borrow up to 85% of the value of your home, you could receive a home equity loan up to $37,500. Here’s how the math works out:
$250,000 x 0.85 (85%) = $212,500 – $175,000 (what you still owe) = $37,500
What Credit Score Will You Need to Qualify for a Home Equity Loan?
A low credit score doesn’t mean you can’t qualify for a home equity loan, but it will affect the terms of your loan. The better your credit score, the lower your interest rate, and the lower your monthly payments. Most home equity lenders are looking for a FICO credit score of 620 or higher.
The chart below outlines the differences in interest rates and monthly payments based on your credit score for a 15-year, $50,000 home equity loan.
FICO credit score
Note: Table is based on national interest rates on Jun 25, 2020.2
In this scenario, a very good credit score would save you $171 on monthly payments compared to a poor credit score. Over the course of the loan, that’s $30,780 total.
Where to Shop for A Home Equity Loan If You Have Bad Credit
Shopping for a second mortgage like a home equity loan is different than searching for a lender for a traditional first mortgage. Even if you have bad credit, you have several options.
When comparing lenders, pay attention to points or any other fees associated with your loan. And if you have any questions, don’t hesitate to ask.
Online digital comparison lenders
Online comparison lender tools can give you several options based on the information you put in the system. These services can save you time, providing a quick way to see potential terms of a loan based on your current credit situation.
Generally, online lenders let you apply digitally, which can also save you time and get you approved for a loan more quickly.
Traditional banks and institutional lending
Visiting the local branch of your bank or credit union can also be a good starting point. If you have an existing relationship with a particular bank or credit union, you’re likely to get better terms on a loan.
The downside is these traditional lenders typically have stricter underwriting guidelines. They may not approve your request for a loan if you don’t meet the minimum credit score requirement.
Mortgage brokers and mortgage banks
Mortgage brokers and banks specialize more in first mortgages, but they may have a limited selection for home equity loans. Often mortgage brokers and banks will refer you elsewhere.
Non-prime home equity lenders
Non-prime and non-QM (QM meaning qualified mortgage) home equity lenders are among the fastest-growing segments of alternative lenders. Alternative lending generally refers to any mortgage lender that doesn’t involve a traditional bank.
These lenders may have more options for folks with bad credit situations than traditional lenders would. But, on the flip side, you’ll likely face higher interest rates and lower LTV requirements.
Alternatives to Home Equity Loans If You Have Bad Credit
If your credit score is keeping you from qualifying for a home equity loan, there are other options.
Like a home equity loan, you’ll still have lender requirements involved with a personal loan. While a better credit score always helps when applying for a loan, you can find lenders who will accept lower scores.
These loans are unsecured, meaning you’re not risking an asset to get one. But you’ll face higher interest rates and a lower loan limit if you have bad credit.
With a cash-out refinance, instead of taking out a second mortgage, you rework your existing mortgage to be higher. You then use the loan to pay the original mortgage and keep the difference.
You may be required to have at least 20% equity in your home to qualify for a cash-out refinance.
While it can be easier to qualify for a cash-out refinance, it might not be the best bet in the long run. Depending on when you bought your home and when you refinance, you could wind up paying more in interest. You’ll also deal with fees and closing costs to refinance.
Shared appreciation agreement
Shared appreciation agreements, also known as shared equity agreements, are complicated, and they’re not a cheap option.
With these agreements, you give an investment company a minor ownership stake in your home and cash out on some of the equity in your property in return.
With fees ranging from 2.5-3%, you won’t get as much equity out of your home as you would with a home equity loan or HELOC.
There’s no monthly loan payment involved. Instead, at the end of the term, you repay the equity advance you received as well as a percentage of the appreciation in the value of the home. Terms are typically 10 years.
Try to Boost Your Credit
To bump your odds of securing a home equity loan, work on ways you can boost your creditworthiness:
- See if there are any errors in your credit report
- Pay your bills on time every month-and pay off as much as you can, but at least make the minimum payment
- To avoid affecting your credit utilization, keep credit cards open after you’ve paid them off
- Don’t max out or open new credit cards