Your home is not only a place to build long-lasting family memories. The house you own can also boost your chances of getting a loan to pay for a big, unexpected expense or kitchen makeover — even if your credit isn’t pristine.
While having bad credit can crush your chances of getting approved for new loans, owning a home that’s worth more than your loan balance can save you because it gives you the option of taking out a home equity loan.
A home equity loan is a secured loan with your house serving as the 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. Because you’re using your home as collateral, a stellar credit score isn’t required for the loan.
How to calculate the size of your home equity loan
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.
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, or HELOC, which act more like a line of credit, according to Bank of America. Both types of loans use your home’s equity to take out cash but in different ways. In both instances, however, 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?
Not all lenders have the same standards for home equity loans. Because of this, you should shop around for rates and terms from many different lenders. Banks will be more likely to approve you for a 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.
- An on-time bill payment history.
- A 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.
“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
A low credit score can hurt your chances of getting approved for many types of loans, including personal loans and auto loans. Having less-than-stellar 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 can still result in less favorable loan terms.
For instance, the lower your credit score, the more you’ll pay in interest. A borrower with a credit score between 620 and 639, for example, is currently be charged an average interest rate of 12.59 percent for a 15-year fixed home equity loan of $50,000. That’s 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 nearly $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 …|
If you have a low credit score, you also may not qualify to borrow as much money. To increase your chances of getting approved for a loan and maximizing your loan amount, you may need to enlist the help of a co-signer who’s more creditworthy than you.
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.
A HELOC also allows you to tap your home’s equity for cash, 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 if the interest rate benchmark they are tied to rises. 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 up to the limit you were approved for, 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.”
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, having the reassurance of a great credit score can be the difference between getting approved and getting denied.
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. 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 or issues you need to address.
- 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.
- Don’t max out or open new credit cards.
- Pay down existing credit cards below 30 percent of the maximum limit.
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.