A home equity loan allows homeowners to convert a portion of their home’s equity into a lump sum of cash. While there are minimum requirements that borrowers must satisfy to qualify, getting a home equity loan with bad credit is possible. Below, we’ll explore the ways in which a person with subpar credit can qualify for a home equity loan. If you’re unsure whether this option or another mortgage product is best for your current and future financial situation, consider working with a financial advisor who can help you identify the best path forward.
What Is a Home Equity Loan?
Also known as a second mortgage, a home equity loan is a type of consumer debt that enables you to borrow from your home’s equity. If your house has gone up in value since you purchased it and/or you’ve paid off a portion of your existing mortgage, a home equity loan is one way to convert that equity into cash, which can be used to make home improvements or meet other financial needs.
For example, imagine you bought a home for $500,000 several years ago with a $400,000 mortgage. Since then, you’ve made $50,000 worth of payments and have also seen the value of your home go up $50,000 in that time. Since equity is calculated by subtracting the money you owe on your home from its current value, you would have $200,000 worth of equity ($550,00 – $350,000) to borrow from using a home equity loan.
This loan option is different from a cash-out refinance, which results in a new loan that replaces your existing mortgage. A home equity loan, on the other hand, is simply a second mortgage with a fixed monthly payment that’s separate from the borrower’s existing mortgage payment.
Home Equity Loan vs. Home Equity Line of Credit (HELOC)
Home equity loans also differ from home equity lines of credit (HELOCs). While both use the home as collateral and leverage the equity that’s been built up in a property, a HELOC is a revolving line of credit that can be tapped as needed up to a certain limit. A HELOC also has an adjustable interest rate that varies over the course of its repayment, so payments are not fixed like they are with home equity loans.
Qualifying for a Home Equity Loan With Bad Credit
If your credit score is in the 500s, chances are you won’t be eligible for a loan. That’s because borrowers typically need a minimum credit score of 620, although some lenders may require a score in the mid- to high-600s. But borrowers with low debt-to-income (DTI) ratios, at least 15% equity in a home and high income can still possibly qualify for a home equity loan regardless of their credit history. This is due to a home equity loan using the home itself as collateral.
Here are the typical requirements for getting a home equity loan. For borrowers with bad credit, these requirements are even more important to satisfy:
- A credit score of 620+: As stated above, most lenders require a credit score of at least 620, however, this minimum will vary depending on the lender. Some lenders may require an even higher minimum score.
- At least 15% equity in your home: To qualify, you’ll also need at least 15% or 20% equity in your home, depending on your lender. Remember, equity is the difference between your home’s current market value (not the original purchase price) and the amount of money you still owe on the mortgage. The more equity you have built in your home, the more money you can potentially borrow from the lender with a second mortgage.
- A maximum DTI of 43%: DTI measures how much monthly debt you carry compared to your gross monthly income. To qualify for a home equity loan, lenders don’t want your monthly debt payments (including your second mortgage) to exceed 43% of your gross income. If your credit is below the required threshold, the lender may want to see an even lower DTI.
- Stable and substantial income: With bad credit, you may need an even higher income than you would otherwise need to qualify for a home equity loan. A consistent, stable income will signal to your lender that you’re less likely to miss payments.
- A history of paying your bills on time: Demonstrating that you consistently pay your bills on time, despite having bad credit, may also help you to secure a home equity loan.
If you have a substantial amount of home equity and can borrow quite a bit less than the lender would receive out of the sale of a home, in the event you fail to pay, then you might still qualify if you don’t meet all requirements. This will be on a case-by-case basis and completely depends on the appetite for risk of the lender.
If you have bad credit, take these six steps before applying for a home equity loan:
Step 1: Determine if Your Need Is Worth it
First consider why you need the loan. A home improvement project that will increase the value of your house or a medical emergency are both appropriate reasons to seek a home equity loan. Buying a new car or investing in cryptocurrency or other risky assets are not good reasons to tap the equity in your home and potentially risk losing it.
Step 2: Calculate Your Equity
Now it’s time to make sure that you have built enough equity in your home to qualify for a second mortgage. To do this, you’ll need to calculate your loan-to-value (LTV) ratio. This metric measures how much the remaining balance on your mortgage is compared to the current value of your home. While your equity is calculated by subtracting the former from the latter, LTV is determined by dividing your remaining loan balance by the home’s market value. Lenders typically won’t let you take out a home equity loan if your combined LTV ratio exceeds 85%, meaning your existing mortgage balance and the second mortgage cannot be more than 85% of your home’s current value.
Step 3: Improve Your Credit Score
Next, review your credit report and work to improve your credit score, if possible. Remember, you’re entitled to request one free credit report each year from the three major credit bureaus: Equifax, Experian and TransUnion. If your credit score isn’t great, there are proactive ways to improve it. First and foremost, ensure that you are paying your bills on time every month, as this has the largest impact on your FICO score. Next, work to pay down existing debt, since your debt utilization rate also significantly affects your credit score. You may also consider paying to boost your credit score using a tool like Experian Boost.
Step 4: Calculate Your Current Debt
Similar to calculating your LTV, taking stock of your current debt is also vital. Make a list of your monthly debt payments and then divide that total by your gross monthly income. If that number exceeds 43%, you may have a difficult time getting a home equity loan, especially with bad credit. Bringing this percentage down below the 43% threshold may improve your chances of being approved for a loan.
Step 5: Shop Around
Next up, compare interest rates from different lenders. It’s important to shop around with various lenders to get a sense of what interest rates are available to borrowers with poor credit. However, the Federal Trade Commission (FTC) also recommends getting in touch with your current lender. “Consider contacting your current lender to see what they offer you as a home equity loan. They may be willing to give you a deal on the interest rate or fees,” according to the federal agency’s website.
Step 6: Consider Getting a Cosigner
Lastly, consider getting someone to cosign a loan with you. Having a cosigner with a stronger credit history, whether it’s a family member or a close friend, can improve your chances of being approved for your home equity loan.
The Risks of Getting a Home Equity Loan With Bad Credit
It’s important to consider the risks of getting a home equity loan with bad credit. Since the home serves as collateral for the loan, defaulting could mean losing the roof over your head. That’s why it’s so important to have your finances in order before starting the process and doing your due diligence.
“Some dishonest lenders target older adults, homeowners with modest means, and borrowers with credit problems. They offer financing based on the equity in your home, not on your ability to repay the balance due,” the FTC warns. “If you fall behind on the payments, the lender can try to declare your financing in default and serve you with a notice of default. Usually, that’s the first step in the foreclosure process.”
Dishonest lenders may assure you that your credit history does not matter, pressure you into a loan before you have time to research other options and suggest you apply to borrow more money than you need, the FTC warns. This can create a number of issues for you down the road, especially if borrow more than you can afford to pay back.
Bad credit will also likely result in a higher interest rate than a borrower with a stronger credit score. This will cost you more money each month and over the term of the loan. That means you’ll have a higher monthly payment, a larger financial obligation to manage, and potentially, a greater risk of defaulting on your loan.
Having bad credit can seriously hamper your ability to borrow money, including home equity loans. However, those with lower credit scores can still qualify for second mortgages with low debt-to-income ratios and at least 15% equity in their home. Borrowers with bad credit scores may also need higher incomes than those with good credit scores, although specific requirements may vary from lender to lender.
Tips for Managing Your Mortgage
- A financial advisor can assess your entire financial situation, including your mortgage obligation, and help you find savings elsewhere in your budget. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- When looking for a mortgage, whether it’s to buy a home or refinance an existing loan, be sure to shop around to find the best rate. SmartAsset’s mortgage comparison tool can help you do just that.
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