It’s an inescapable fact that having poor credit means you face a tougher time borrowing money, including when it comes to qualifying for a home equity loan.
A home equity loan is a secured loan with your house serving as collateral, which offers the bank some “security” in the event you don’t pay them back. Simply put, you’re borrowing against your house and the equity you’ve built up. Equity is the difference between the appraised value of your home and the amount you still owe on your mortgage.
Getting a home equity loan with bad credit is possible but it all depends on a number of factors, including just how poor your credit is. Before applying, see what you need to obtain a home equity loan even with bad credit.
How do I qualify for a home equity loan if I have bad credit?
Not all lenders have the same standards for home equity loans. Because of this, you should shop around for rates and terms from multiple lenders. Banks will be more likely to approve you for a home equity loan if you have:
- At least 15 percent to 20 percent equity in your home.
- A minimum credit score of 620, based on a range of 300 to 850.
- A maximum debt-to-income ratio (DTI) of 43 percent, or up to 50 percent in some cases.
- On-time bill payment history.
- Stable employment and income history.
If your credit isn’t great, lenders may require that you carry less debt relative to your income and have more equity in your home.
Why you need to check your debt-to-income ratio
Your debt-to-income ratio, or DTI, divides your monthly debt by your monthly gross income. You can calculate your DTI using this Bankrate calculator. Otherwise, add up all your monthly debt, including all your loans, credit card payments, and any other financial obligations. Then divide this by your monthly income. For example, your monthly debt is $2,000 and your monthly income is $5,000.
$2,000 / $5,000 = 40 percent DTI
A higher DTI is a turnoff to lenders. A high DTI means you have less money to put towards other expenses, like a home equity loan. Even if you’re making payments, there’s a chance you could experience a financial hardship that would make it difficult — or even impossible — to repay your home equity loan.
You’ll want to keep your DTI as low as you can, but ideally less than 43 percent.
How to calculate the size of your home equity loan
If you qualify for a home equity loan, you’ll generally repay it at a fixed interest rate over a set period, usually between five and 15 years. Minimum loan amounts can range from $10,000 to $25,000, depending on the lender.
The maximum amount you can borrow is based on your loan-to-value ratio or LTV. The LTV ratio is calculated as a percentage by dividing your remaining loan balance by the home’s current value. Here’s an example:
An appraiser determines your home is worth $400,000. You still owe $250,000 on the loan so your LTV is 62.5 percent. If your lender allows up to an 85 percent LTV, that means you can get a home equity loan up to $90,000.
Here’s how the math works: $400,000 x 0.85 = $340,000 – $250,000 = $90,000
Home equity loans are different from a home equity line of credit, which is a revolving line of credit rather than a lump-sum loan. Both types use your home’s equity to take out cash and your home is collateral, so a lender can foreclose if you fail to make payments.
The impact of low credit scores on home equity loans
A low credit score can hurt your chances of getting approved for many types of loans, including personal loans and auto loans. Having tarnished credit could also pose challenges when applying for a home equity loan. But even if you’re approved for a home equity loan, a low credit score means potentially facing higher interest and monthly payments.
For instance, a borrower with a credit score between 620 and 639 would pay an average interest rate of 11.92 percent for a 15-year fixed home equity loan of $50,000. That’s more than double the interest rate of a borrower with a top-tier credit rating, according to FICO data. Someone with a poor credit score will pay almost $200 more each month for the same size loan. See the chart below.
Interest rates and payments for a 15-year, $50,000 home equity loan:
|If your FICO score is …||Your interest rate is …||And your monthly payment will be …|
Home equity loan alternatives if you have bad credit
Not having great credit might mean not qualifying for a home equity loan. But you have other options to consider as well.
Just as lender requirements vary for home equity loans, the same applies to personal loans. A bad credit score may get you denied, but some lenders have options for low-score borrowers. You just have to look for them.
Personal loans usually have faster repayment terms, usually up to five or seven years. This means that your monthly payments could be higher than a home equity loan. Some lenders allow loans up to $100,000, which is comparable to a home equity loan. But many lenders cap their amounts at half that or less. This could impact which lender you choose.
Because personal loans are unsecured, you’ll need a good credit score to qualify. There are personal loans available if you have bad credit, but your interest rate will be much higher compared with a home equity loan.
With a cash-out refinance, you pay off your existing mortgage with a new, larger loan, and you receive the difference in cash. Like other home equity products, many lenders require you to have at least 20 percent equity in your home for a cash-out refinance.
Unless you can get an equal or lower interest rate, a cash-out refinance might not be the best move. You’ll pay more in interest over the life of the loan, which could be 15 to 30 years. Don’t forget that refinancing a mortgage comes with lender fees and closing costs, too.
Work on boosting your credit
To increase your chances of getting approved, work on improving your credit and reducing your debt relative to your income.
- Check your credit report to see if there are any errors, like lines of credit you didn’t open or other issues, like overdue payments..
- Pay bills on time every month. At the very least, make the minimum payment. But try your best to pay the balance off completely.
- Don’t close credit cards after you pay them off — either leave them alone or have a small, recurring payment on there that you can pay off every month. Closing cards reduces your credit utilization and can cause your credit score to dip.
- Don’t max out or open new credit cards. Maxing out your cards gives you a high credit utilization rate, making you look like an irresponsible credit user.
- Pay down existing credit card debt to stay below the recommended 30 percent utilization rate.
Fixing your credit won’t happen overnight. It takes discipline and time. But the rewards — boosting your creditworthiness and gaining financial freedom — are worth it.