Home equity loans are a way for property owners to turn the unencumbered value of their home's equity into cash. And if you have bad credit, a home equity loan is more likely to be approved by a lender—and at a lower interest rate—than either a traditional loan or a revolving line of credit. The reason is that your home serves as the security (collateral) for the loan, making you less of a financial risk in a lender’s eyes.
Lenders will typically make loans for up to 80% of the equity you have in your home. The more equity you have, the more attractive a candidate you will be, especially if you own 20% or more of the home free and clear. This can be particularly helpful when you have a poor credit score. Here, we take a closer look at landing a home equity loan if you have relatively bad credit.
Key Takeaways
- Home equity loans allow property owners to borrow against the debt-free value of their homes.
- If you have bad credit, you may still be able to get a home equity loan since the loan is backed by the home itself as collateral.
- A major downside, then, is that you will be putting your home at risk if you can’t repay as you take on more debt with the loan.
Downsides of Home Equity Loans
While a home equity loan can be useful if you have bad credit, there are some important downsides to understand. You can expect less favorable terms on your home equity financing, for example, than if your credit were better. You may be limited to a lower loan amount and have to put up more collateral (i.e., greater equity). You may also have to pay a higher interest rate over the life of the loan.
A home equity loan also adds to your total mortgage debt on the property, which could put you in a vulnerable position if you lose your job or face unexpected bills and find it difficult to make all of your payments on time. What’s more,you may get hit with hefty late-payment fees that your lender will report to the credit bureaus, making your credit even worse.
The biggest downside is that the lender could ultimately foreclose on your property if you’re unable to pay the debt, leaving you without a place to live.
With these important drawbacks in mind, there are a number of alternatives that you may consider rather than using your home equity as collateral for a loan. Even if you have less-than-stellar credit, you may be able to access some emergency loan options to help you weather a financial emergency without risking your home.
Home Equity Loans vs. HELOCs
There are two main options for home equity financing. With a home equity loan, you borrow a lump sum of money and repay it in regular installments, typically at a fixed interest rate, over anywhere from 10 to 30 years.
The second type is a home equity line of credit (HELOC), in which the lender sets aside an amount of money that you can borrow from as needed on a revolving basis. Most HELOCs charge adjustable interest rates, offer interest-only payments, and have a five- to 10-year draw period, during which you can access the funds.After the draw period ends, you have to repay the outstanding balance over a specific period, typically 10 to 20 years, but sometimes it is a balloon payment that requires payment in full.
Steps to Take Before You Apply
Here is what you need to know and do before applying for any type of home equity financing.
Read Your Credit Report
Get a copy of your credit report so you know exactly what you’re up against. You’re entitled to a free one every year from each of the three major national credit bureaus (Equifax, Experian, and TransUnion) through the official website authorized by federal law. Check the report thoroughly to make sure there are no errors that are hurting your score (it’s smart to do this every year anyway).
Prepare Your Financials
Gather your financial information, such as proof of income and investments, so it’s ready to present to lending institutions. They’ll want to see in black and white that you’re financially stable enough to support your loan, especially if you’ve got bad credit.If possible, pay off any outstanding debt that could adversely impact your application.
If borrowing can wait, you might want to use the time to improve your credit score.
Consider How Much Cash You Need
Ask yourself: What is the purpose of this loan? And how much money do I need for that purpose? It can be tempting to shoot for the stars and maximize your loan amount, perhaps to provide a financial cushion just in case. Still, that’s only if you’re sure you can resist the temptation to spend it all. If your spending habits are under control, it may make sense to “borrow up,” and by using a HELOC, you’re only paying interest on the money you actually take out.
However, in the case of a home equity loan, you’ll be paying full interest (and principal) on the entire lump sum, so it makes sense to borrow no more than you need.
Compare Interest Rates
It’s logical to head straight to your existing lender for home equity financing. Given that you’re already a client, that lender may offer a more appealing rate. However, there is no such thing as a guaranteed home equity loan if you have bad credit, so it’s wise to shop around.By obtaining multiple quotes, you’ll be in a better position to negotiate the best possible rate. Present your best offer to another lending institution and see if it will beat it.
An independent mortgage broker may also be of help since they work for you and not the lender.
Don’t Forget the Other Costs
When you’re comparing loan offers, don’t focus solely on the interest rate. Be sure to ask about any other associated fees, such as loan processing and closing costs. That way you can compare loans on a fair basis and won’t be in for any budget-busting surprises later on.
Recruit a Co-Signer
To put yourself in a better position to borrow, it may be a good idea to bring in a co-signer, someone who uses their credit history and income to serve as a guarantor for the loan. Choose a co-signer with impressive credit, good job stability, and significant income to maximize your chance of approval. That person, of course, should be aware of the risks of co-signing a loan if you are unable to pay it back.
Possibly Look at Subprime Loans
As a last resort, you can turn to lenders offering subprime loans, which are easier to qualify for and targeted to poor-credit borrowers who don’t meet traditional lending requirements.
Subprime lenders typically offer lower loan limits and significantly higher rates of interest. However, you should avoid these loans if at all possible, especially if you are already in credit trouble.
What's the Difference Between a Home Equity Loan and a HELOC?
A home equity loan is a lump sum of money that comes with fixed payments and a fixed interest rate for the term of the loan. A HELOC, on the other hand, is a revolving credit line that allows a borrower to tap into their equity as needed, up to a certain preset credit limit. A HELOC has a variable interest rate and the payments are not usually fixed.
What Is the Minimum Credit Score to Qualify for a Home Equity Loan or HELOC?
Although the requirements to qualify for a home equity loan or HELOC vary by lender, you’ll likely need a FICO score of at least 680. Some lenders may accept credit scores as low as 620, but most may prefer it to be 720 or more.
What Are Other Requirements for a Home Equity Loan or HELOC?
Besides a credit score usually greater than 680, borrowers need more than 20% equity in their home and a stable, verifiable income history for two-plus years.
If you don't meet these requirements, you can still get approved by using a lender that specializes in high-risk borrowers—but expect to pay much higher interest rates.
Mortgage lending discrimination is illegal. If you think you've been discriminated against based on race, religion, sex, marital status, use of public assistance, national origin, disability, or age, there are steps you can take. One such step is to file a report to the Consumer Financial Protection Bureau or with the U.S. Department of Housing and Urban Development (HUD).
The Bottom Line
If you find that poor credit history is working against you, ask your lenderwhat it would need to see from you (and your credit report) to improve your prospects. It’s never too late to turn your credit score around. If possible, consider putting your borrowing plans on hold while you take steps to improve your rating.
Mortgage lenders typically look at such factors as your payment history, existing debt load, and how long you’ve had your credit accounts. Do you frequently miss payments, run up big balances, or apply for new accounts? Just changing one of these behaviors can positively affect your credit score—and make future borrowing easier.
