Can You Get A Home Equity Loan With Bad Credit?

If you think getting a home equity loan with bad credit is impossible, think again. While it may be harder to qualify, you can get a home equity loan with bad credit if you follow certain strategies to improve your chances. Follow along to see what you need to know to get a home equity loan with bad credit.

Can You Qualify For A Home Equity Loan With Bad Credit?

While it may be more difficult, it is possible to qualify for a home equity loan if you have bad credit. But before we get into the details of how to qualify, let’s clarify what a home equity loan is. A home equity loan is a type of second mortgage that allows you to exchange part of the equity in your home for a lump sum payment. Once you receive the payment, you will pay off the loan with fixed-rate payments over a period of years. 

A home equity loan is a great way for homeowners with a large purchase on the horizon, such as college tuition, to utilize their home’s equity by turning it into cash. But before you can get the cash you need, you have to qualify for the loan. Bad credit can make the process harder, but not impossible.

What Is Considered Bad Credit?

Someone is generally considered to have bad credit if they fall below 620 on the FICO® credit score scale. You can get to this score by missing debt payments, having high credit utilization, or defaulting on loans. However, this does not mean you will be automatically denied if your credit score is below 620 as there are several other factors that lenders consider in your application.

Requirements For A Home Equity Loan

Below are some of the main factors that lenders consider when analyzing your application for a home equity loan. While the exact requirements vary among lenders, there are some general guidelines that most lenders will follow.

●      Credit score

●      Debt-to-income (DTI) ratio

●      Amount of home equity

●      Income requirements

Pros And Cons Of Getting A Home Equity Loan With Bad Credit

There are positives and negatives when it comes to getting a home equity loan with bad credit:

Pros

●      Fixed interest rate: Knowing how much you will owe every month allows you to plan your finances far in advance.

●      Debt consolidation: Home equity loans are a great way to consolidate several sources of high-interest debt into one easy to manage loan with a lower interest rate.

●      Potential for tax benefits: You may be able to deduct the interest you pay on your home equity loan on your taxes.

Cons

●      Loan limits: Lenders typically limit the amount that borrowers with bad credit can receive with a home equity loan.

●      Higher interest rate: If you qualify for a home equity loan, you will pay higher interest rates than those with good credit scores.

●      You’re risking your home: Home equity loans use your home as collateral for the loan, so if you fail to make payments, you could lose your home to foreclosure.

How To Apply For A Home Equity Loan If You Have Poor Credit

Follow these steps to apply for a home equity loan.

1. Look At Your Credit Report

The first critical step toward getting a home equity loan with bad credit is to look at your credit report to see where you can improve. Your credit report is more than just your credit score. Your report will give you an in-depth look at your credit history, including your credit utilization, payment history and types of credit. Studying this report will give you insights into how your credit score declined and how you can turn it around. For example, if you have never missed a debt payment but high credit utilization is bringing your score down, you can formulate a plan to increase your debt payments to get this number to an acceptable level.

2. Determine Your Home Equity

Once you’ve reviewed your credit report, it's time to determine how much equity you have in your home. This will be a large factor in determining the size of your loan. To calculate your home equity, subtract your home’s value from the amount you still owe on your mortgage.

For example, if your home is worth $500,000 and you still owe $175,000 on it, you have $325,000 in equity. Remember that a lender will typically require you to keep 15% – 20% of the home’s value in equity, so you will not be able to take out the full $300,000 with a home equity loan.

Let’s say your lender requires you to retain 20% of your home’s value in equity. That means the most you will be able to borrow is 80% of your home’s value, minus the amount you still owe on the first mortgage.

To determine the maximum amount you can borrow, multiply your home’s value ($500,000) by 80% (0.8) then subtract the amount you still owe ($175,000). Using this equation, the maximum amount you can borrow with a home equity loan is $225,000. You can also see the equation below:

($500,000 x 0.80) - $175,000 = $225,000

3. Calculate Your DTI Ratio

Your debt-to-income (DTI) ratio is a percentage showing how much of your monthly income is used on monthly debt payments. This is a key metric for lenders to determine your ability to repay a loan.

To calculate your DTI, start by adding up all of your monthly debt payments. This includes payments for your rent or mortgage, credit cards, auto loans, student loans and any other monthly debt payments you may have. Next, divide that figure by your gross monthly income. That is your income before taxes or deductions. Then divide your debt payments by your monthly gross income and multiply by 100. That number is your DTI ratio shown as a percentage.

If your debt payments total $2,000 and your income is $5,500, your DTI equation will look like this:

($2,000 / $5,500) = .36 x 100 = 36%

4. Find Someone To Co-Sign

Finding a co-signer is a great way to improve your chances of getting a home equity loan if you have bad credit. A co-signer is someone who agrees to make payments on your loan if you cannot. A co-signer with good credit decreases risk for the lender because they act as a backup in case the primary borrower cannot make payments. However, this arrangement is also a risk for the co-signer. If the primary borrower cannot keep up with the loan, they must start making the payments or take a big hit to their credit.

Unlike working to improve your own credit, a co-signer can help your chances of qualifying for a home equity loan immediately instead of taking the time to pay down debt, correct errors in your credit report or take other steps to improve your credit score.

5. Write A Letter Of Explanation

A letter of explanation is a document that explains anything in your credit report that might cause lenders to deny you a home equity loan. This letter can be a valuable tool to clarify negative marks in your credit report, such as previous bankruptcies, foreclosures or missed payments. While these marks alone may jeopardize your ability to qualify for a home equity loan with bad credit, a letter explaining those situations and how you have improved your financial situation since can go a long way.

A letter of explanation is also a great way to explain non-derogatory information in your credit report that a lender may view negatively without context. For example, if you have long gaps in your employment history because you were caring for a child, went back to school or were self-employed, you can explain the details in a letter of explanation.

Tips For Getting A Home Equity Loan With Bad Credit

Here are some helpful tactics to improve your chances of getting a home equity loan with bad credit:

●      Compare lenders: shopping around for lenders is the best way to determine the range of interest rates and loan terms you can qualify for with bad credit. Comparing both new lenders and those you have an existing relationship with is a good way to view the full spectrum of options available to you.

●      Lower your DTI: The two ways to lower your DTI is to either pay down debt or increase your income. Side gigs like ride-booking are a great way to increase your income immediately and paying down high-interest credit card debt is a good first target to use that extra cash on.

●      Dispute errors on your credit report: You should also do a thorough check for errors in your credit report that might be hurting your credit score without your knowledge. If you find an error, you should report it to the credit reporting bureaus (Experian™, Equifax® and TransUnion®) and the company that reported the error.

●      Make your payments on time: A great way to dispel a lender’s concern about missed payments in the past is to build a recent history of consistent on-time payments.

Alternatives To A Home Equity Loan For Those With Bad Credit

Home equity loans are not your only option. Below are some other loan types you may qualify for.

Cash-Out Refinance

A cash-out refinance can be a great alternative to a home equity loan if you don’t want to manage two mortgage payments. Instead of taking out a second loan, a cash-out refinance allows you to pay off your current mortgage, exchange your equity for cash, and sign another larger mortgage loan for the home. This transaction gets you a lump sum of cash just like a home equity loan.

Cash-out refinances are great if you only have to pay one mortgage payment after the deal is done. If you’re lucky, the interest rate might be lower than your previous mortgage. So while you will have to make mortgage payments for a longer period of time, each payment may be smaller.

Home Equity Line Of Credit

A home equity line of credit (HELOC) is similar to a home equity loan with a few key differences. With a HELOC, you utilize your home’s equity, but instead of a lump sum payment, you get access to a revolving line of credit with a limit, similar to a credit card. The key benefit if you have bad credit is that you only make payments on the money you withdraw from the HELOC. So if you don’t know how much money you need, you can take out minimal amounts at a time, making repayment more manageable over time.

Another key difference from home equity loans is that the interest on HELOCs is variable. So when you do withdraw funds, the interest rate may fluctuate depending on the health of the financial market. While you have more control over how much money you borrow, it may be harder to predict your monthly payments looking forward if interest rates change.

Personal Loan

A personal loan is a good alternative to a home equity loan if you do not have enough equity built up in your home and need a smaller amount of money. Personal loans are typically unsecured, meaning you do not have to put up any collateral to receive the loan. While this means you don’t have to risk any valuable assets if you fail to make payments, the arrangement is riskier for lenders. To deal with this added risk, personal loans generally provide a lower amount of money than a home equity loan that is secured by your home.

FAQs About Getting A Home Equity Loan With Bad Credit

Can I get a home equity loan with a 500 credit score?

Getting a home equity loan with a 500 credit score will be extremely difficult, but not impossible. Conditions that will help your chances of qualifying include a large amount of home equity built up, a low DTI thanks to high income or minimal existing debts, or a co-signer with excellent credit.

Is it hard to get a home equity loan with bad credit?

It is more difficult to get a home equity loan with bad credit, but as we’ve mentioned above, it is not impossible. Several lenders offer home equity loans to borrowers with bad credit if they meet other criteria.

What’s the lowest credit score to get a home equity loan?

Lenders typically require a credit score of at least 620 to qualify for a home equity loan. However, other factors can improve your chances of getting a home equity loan if you have bad credit.

The Bottom Line

It is possible to qualify for a home equity loan even if you have bad credit if you meet several other criteria that lenders look for when considering applications. The most important factors include your DTI ratio, the amount of equity you have in your home, and your income level. If you still don’t meet the requirements for a home equity loan, sign up for Rocket Money^SM to take control of your finances and start improving your credit.