Getting rejected for loans because you have bad credit can be discouraging. But take heart because your home’s equity may provide a lifeline when you need cash.
A home equity loan is a lump sum secured by the equity you’ve built in your home. Equity is the difference between the appraised value of your home and the amount you still owe on your mortgage.
How does a home equity loan work?
You repay a home equity loan 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.
$400,000 x 0.85 = $340,000 – $250,000 = $90,000
Home equity loans are sometimes confused with a home equity line of credit, or HELOC. Both use your home’s equity to take out cash but in different ways. (We’ll cover HELOCs in more detail later.) In both instances, your home is collateral, so a lender can foreclose if you fail to make loan payments.
How do I qualify for a home equity loan if I have bad credit?
Lenders have varying credit standards for home equity loans so it’s important to shop rates and terms with different lenders, just as you would with a purchase mortgage. Here are some common requirements:
- At least 15 to 20 percent equity in your home.
- A minimum credit score of 620.
- A maximum debt-to-income ratio (DTI) of 43 percent, or up to 50 percent in some cases.
- An on-time bill payment history.
- A stable employment and income history.
If your credit is tarnished, lenders may require that you have a lower DTI and more equity in your home as a percentage of its value.
“A poor credit record may turn off some home equity lenders altogether, while others may look for a compensating factor, such as the borrower retaining a larger equity stake in the property,” says Greg McBride, CFA, chief financial analyst at Bankrate.com. “Lenders have become much more diligent about loans made in the second-lien position since the financial crisis.”
The impact of low credit scores
For starters, the lower your credit score, the more interest you’ll pay. Someone with an excellent score of 740 or above might pay 5.99 percent interest on a 15-year home equity loan (according to recent averages), while a borrower with a score of 620 would pay closer to 12 percent. That adds up to an additional $178 a month in interest paid on the loan.
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If you have a low score, you may not be able to borrow as much money. You may be asked to add a more creditworthy co-signer, usually a friend or family member, on the loan.
One option to consider: Work with a credit union, says Johnna Camarillo, assistant vice president of equity processing and closing with Navy Federal Credit Union. Credit unions tend to have more underwriting flexibility because they keep many of their loans in-house rather than sell them to investors.
Navy Federal doesn’t have minimum credit score requirements for home equity loans, Camarillo says. Instead, the credit union looks at a borrower’s entire financial picture, including earnings, debts and repayment history, she adds.
What are other loan alternatives if I have bad credit?
HELOC: A HELOC allows you to use your home’s equity, but it’s a line of credit that you use as needed rather than a fixed lump sum. These loans come with a variable interest rate, meaning they can go up or down from month to month. Lenders typically require a minimum credit score of 620 for a HELOC, but some may have higher minimums.
A HELOC is split into two parts: the draw period and the repayment period. The initial draw period lasts an average of 10 years, and you can access as much as you want, whenever you want. You’ll pay interest only on the amount you draw. After the draw period ends, the repayment period begins. You’ll make monthly payments on the principal amount and interest for a period of up to 20 years.
The variable rates that come with a HELOC can spiral out of control for some borrowers who struggle with their finances, says Sacha Ferrandi, co-founder and CEO of Source Capital Funding.
“If your ability to meet payments is already poor, or you overspend, you’d be staring down an insurmountable spike in rates,” says Ferrandi, adding that HELOCs can be even riskier for people with a lot of debt. “Some people use HELOCs as a form of debt consolidation, but if you default on your payments, you lose the house altogether.”
Cash-out refinance: 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 a lower interest rate, a cash-out refinance might not be the best move. Why? 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
Tapping your home’s equity to upgrade your home, pay college tuition or consolidate high-interest debt can be useful. But be careful not to bite off more than you can chew, especially if you have lackluster credit.
“Borrowers need to understand how the loans will impact their monthly budgets, including how much money they will have left over for discretionary spending like eating out, vacations or going to the movies,” Camarillo says.
To increase your chances of getting approved for one of these loans, work on improving your credit and DTI ratio. Here are a few quick tips to get started:
- Check your credit to see if there are any errors or issues you need to address.
- Pay bills on time and in full every month.
- Leave older debts in collections alone; they come off your credit report after seven years.
- Don’t close credit cards after you pay them off, especially if they’ve been open a long time.
- Don’t max out your open credit lines or make large purchases.
- Pay down existing credit cards below 30 percent of the maximum limit.
- Avoid taking out new credit cards or loans in the months before you take out a new loan.
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.