A less-than-perfect credit score isn't necessarily a barrier between you and a home equity loan (definition courtesy of MagnifyMoney’s parent company, LendingTree). Why? Because unlike unsecured debts, such as personal loans or credit cards, you actually have some valuable collateral to offer the lender — your home. So while you may still face a difficult road ahead in pursuit of such a loan, for many it's more than doable.
When applying for a home equity loan (HEL), you're essentially leveraging the equity you've built up in your home. By equity, we mean the difference between the value of the home and whatever's currently left on your mortgage. If, for example, an appraisal finds that your home is worth $150,000, and your mortgage balance is $100,000, then you have $50,000 of equity. (You can find a handy LendingTree equity calculator here.)
Generally speaking, more equity translates to more robust financing options, even if you have poor credit. That's not to say you'll get the best terms and interest rates. (We’ll get back to that.) But even if you’re squarely in this camp, there are options out there.
The application process for a HEL, which isn't unlike that of a mortgage, can be lengthy. Get ahead of the game by gathering up all the relevant financial documentation. This includes your latest tax returns, proof of income and employment, home insurance documents, your home value estimate and the like. Any co-applicants ought to do the same.
What's considered a "bad credit score" for a home equity loan?
Getting a home equity loan with bad credit is possible, but as with any other type of financing option, a good score is bound to work in your favor.
"Anything under 680 is going to be where things get a little difficult," Nathan Pierce, a certified residential mortgage specialist and vice president of the National Association of Mortgage Brokers (NAMB), tells MagnifyMoney.
Of course, this isn’t a hard and fast rule Discover, for example, offers HELs to consumers with credit scores as low as 620.
If your score is on the lower side of the 600s, you aren’t necessarily out of the game. Lenders look at other factors besides your score. They also consider whether you have a history of responsible credit use, solid employment and income, and sufficient equity in your home.
Other factors that can impact your quest for a HEL
Debt-to-income ratio: Aim for 43 percent or less
Qualifying for a home equity loan with bad credit is about more than just your credit score. During the process, a number of factors come into play. Your debt-to-income (DTI) ratio is a biggie. This basically provides a snapshot of what you owe versus what you earn.
Many lender sites specify the 43 percent threshold. According to Pierce, a DTI that exceeds 45 percent will likely work against you when applying for a home equity loan.
"You may see some lenders that may go up to 48 percent or 50 percent, but that's on the rare side," he adds.
In general, lenders tend to lean more conservatively here. And, as we said, 43 percent is a big number for many lenders. The maximum DTI for applying through both Chase and TD Bank, for example, is 43 percent.Let's say your monthly gross income stands at $4,000 and all your monthly debt payments (from your mortgage to credit cards to student debt to auto loans) adds up to $3,000. When we divide your debt by your income, it reveals a 75 percent DTI. That is an amount that's considered high by HEL standards, which will probably impact your ability to qualify for a home equity loan in spite of bad credit.
Loan-to-value ratio: Aim for 85 percent or less
How much equity you have in your home is another big piece of the puzzle, as it affects how much money you'll be able to borrow. Since you're using the home itself as collateral, owing less makes you more desirable to lenders.
It'll also help you get approved for a larger loan amount. If your mortgage debt exceeds 85 percent of the home's value, qualifying for a home equity loan with bad credit might prove tricky. This calculation is called the loan-to-value ratio. (You may encounter the acronym LTV.)
"For most lenders, that's the bottom number," says Pierce. "When you get up to 90 percent, it gets a little bit thinner, but there are some institutions out there that are going to 100 percent these days.”
Most of these will be credit unions and small community banks, as opposed to traditional banks and mortgage companies. The big guys, according to Pierce, are usually limited to 85 to 90 percent.
Low equity, when coupled with poor credit, is likely to make qualifying for a HEL an uphill battle. That's not to say you're out of options; you just might have to take a different financing route.
Your credit report: Getting it right
That said, you'll definitely want to take a good look at your credit report before applying for a HEL. According to a 2012 Federal Trade Commission report, roughly one in five Americans has potential errors on his or her credit report. If you're one of these people, disputing errors with credit bureaus can give your credit score a nice boost in the right direction. Indeed, 13 percent of consumers experienced a change in score due to their dispute, the report said.
Legitimate red marks on your report, like delinquent accounts or a past bankruptcy, could indeed makes things harder, but every lender is different.
How to shop for a HEL with bad credit
Before making any big financial decision, it's in your best interest to shop around. Don't let having poor credit score or disempower you or make you feel like you need to jump at the first offer. Instead, leverage what equity you have in your home to negotiate multiple offers and try to score the best terms you can.
"With a home equity loan, there could be large variations between lenders, so I'd definitely suggest checking with multiple places, as you could get pretty different options from each," says Pierce.
Just remember that the qualifying criteria for one lender might not match another’s. But that’s all the more reason to do your homework. (Oh, and by the way: if you sign loan papers and then change your mind, the Federal Trade Commission says you have the right to cancel the deal for any reason, without penalty, within three days.)
Additionally, Pierce says that large banks and mortgage brokers might not be your best option. So check out your local community banks and credit unions, which will likely be more open to working with people who have less-than-perfect credit.
What to expect during the HEL application process
After submitting the necessary paperwork, the application process typically takes a few weeks. This may vary depending on the complexity of the application, underscoring the importance of being prepared. If a lender needs to dive deeper to verify your income or look into other properties or assets you have, it'll draw out the timeline.
That said, folks with good credit are more likely to snag financing options with better terms and lower interest rates. This doesn't mean you're out of luck if your credit score is on the lower end, but applying for a home equity loan with bad credit may result in being offered less or paying a bit more in the long run because of higher interest rates. This is when you really need to compare your options, which is why shopping around can pay off big time.
You also need to think about why you're seeking the loan in the first place. For example, a home equity loan with a 10 percent interest rate that's used for a home renovation — which could ultimately boost your home value — might make sense if you have room in your budget to easily absorb the monthly payment. But the same loan doesn't add up if you're looking to consolidate lower-interest debt. Sure, you might boost your credit score a bit, but you'll pay more over the long haul.
Either way, be sure to really pay attention to the loan terms, especially the monthly payments. The good news is that HELs come with fixed rates, and the repayment window seem to fall in the five- to 30-year range. But if the payments are going to strain your budget, you might be better off going with an unsecured line of credit. You'll pay more in interest, but defaulting on a HEL could result in you losing your house — no small thing.
The application process for someone with poor credit might also involve lenders limiting the amount of money they'll let you borrow. And while hashing out loan terms and interest rates, Pierce adds that many lenders will set minimum loan amounts as well.
"You may have lenders that say they want a $25,000 minimum loan amount [if] they're not interested in $10,000 or $15,000, which may be another factor that stops somebody from getting it,” he tells MagnifyMoney.
How to improve your chances of a HEL approval with bad credit
Reduce your DTI
If you've got a few strikes against you, rest easy; there are a number of things you can do to improve your odds of qualifying for a HEL. As we mentioned, reducing your debt-to-income ratio is a big one. Take a look at your monthly budget to see where you can free up extra cash to redirect toward your debt. Minor tweaks, from shrinking your cable bill to eating out less, can make a big difference; $50 here and $25 there, when used to accelerate your debt payments, will supercharge your efforts to improve your score.
While it may not be as easy to dramatically increase your salary, you can give your income a nice boost by picking up a side gig or taking on a roommate to reduce your monthly mortgage burden. The idea is to get creative and find something that works for your lifestyle. The freed-up cash can help dig you out of debt faster, which will also improve your credit score and bolster your chances of being approved for a HEL.
Bring on a co-signer
As with applying for a student loan or a traditional mortgage, introducing a co-signer can be a game changer.
Pierce says bringing a co-signer with good credit on board is a good move because lenders will feel a little safer taking a chance on you. Just do your homework, as different lenders have different qualifying options.
Wait until you have more equity
This might take a bit more time, but remember: More equity translates to a higher LTV (loan-to-value) ratio, which tips the scale in your favor when shopping around for a home equity loan.
Just as we discussed upping your take-home pay and trimming your budget to accelerate your debt payments, the same can be said for fast-tracking mortgage payments. Hacking away at the principal balance will cut the loan down quicker — and grow your equity at a faster clip. This tactic may prove tricky if you're also tackling high-interest debt, but if you have the wiggle room in your budget, it could help reduce your timeline.
Alternatives to a HEL
If you’re having trouble qualifying for a home equity loan with bad credit, you also have some other financing options to explore:
- What it is: A cash-out refinance lets you start over with a new mortgage that replaces your old one while letting you borrow extra that you can use as you wish.
- Why might it be a good alternative? You'll have one new monthly mortgage payment. If you refinance to a longer-term mortgage, that'll also improve your credit utilization ratio, which can help boost your credit score.
- Would someone with bad credit qualify? It depends on the situation. You may qualify, but with a higher interest rate. Pierce adds that, when compared with a HEL, there may be more limits in terms of how much cash you can take out
- What it is: A personal loan is an unsecured loan. If you qualify, a lender will deposit cash right into your account that you can use any way you wish. It can be a good way to consolidate and pay off debt, so long as you can afford the monthly payment.
- Why might it be a good alternative? No collateral. If keeping up with HEL payments means stretching your budget (and potentially defaulting), this option has an advantage: You won't risk losing your home.
- Would someone with bad credit qualify? Probably, but think carefully. Interest rates for people with bad credit can in some instances be upward of 35 percent. Lenders may also tack on an origination fee and/or prepayment penalty
Home equity line of credit (HELOC)
- What it is: A little different from a HEL, a home equity line of credit (HELOC) is a revolving credit line extended to you by the lender.
- Why might it be a good alternative? Your equity level dictates your credit limit, but you can borrow against a HELOC as much as you need to during what's called the "draw period," which usually lasts five to 10 years. (Side note: you'll be on the hook for making interest payments during this time.)
- Would someone with bad credit qualify? If you don't have a lot of equity and/or you have a spotty credit history, getting approved for a HELOC is apt to be as challenging as snagging a HEL, Pierce says.
Getting approved for a home equity loan with bad credit is tough, but it is not impossible. The most powerful tool in your arsenal: to gradually improve your score by making consistent, on-time payments. This, in turn, will reduce your debt while improving your debt-to-income ratio. Keeping up with your mortgage payments will also help you steadily build more home equity.
Plus, you've got other options. Aside from potentially bringing on a co-signer, a cash-out refinance, personal loan or HELOC all represent viable alternatives, depending on what you need the money for and what terms and interest rates you can snag.