How to Get a Home Equity Loan with Bad Credit

How to Get a Home Equity Loan With Bad Credit
Aly J. YaleMarch 13, 2022
Key Takeaways:
  • If you have bad credit, home equity financing is probably the cheapest financing available for debt consolidation.
  • You’ll probably need a low loan-to-value to get a home equity loan or HELOC with bad credit.
  • FHA or VA cash-out refinancing is another option that might work for you.

It’s not impossible to get a home equity loan with bad credit. Though a low credit score could certainly make it harder to get a loan — and potentially more expensive, too — there are ways to make it happen.

Are you looking to tap your home equity to cover home repairs, medical bills, college tuition, or credit card debt but don’t have a perfect credit score? Here’s what you can do to succeed.

Know your credit score — and try to improve it.

Pulling your credit report and score should be your first step. You can do this at AnnualCreditReport.com, or, in many cases, your bank or credit union will offer you free access to your report and score. 

Generally speaking, you need at least a 620 credit score to qualify for a home equity loan, though some lenders allow lower scores case-by-case. If your score is currently below this threshold, you’ll want to work on improving it — not just to increase your chances of qualifying but to ensure you get a reasonable interest rate as well. 

To start, scan your credit report for any errors. If there are accounts you don’t recognize, or a creditor has incorrectly marked something late, alert the credit bureau. Once the issue is corrected, it could improve your score. 

If you’re in a hurry, your lender might even be able to help you with rapid rescoring. Mortgage lenders can access the service, correcting credit report errors in just a couple of days for a nominal fee. You’ll need to document the mistake – for instance, by providing a canceled check proving that you did pay on time.

You can also:

  • Set up autopay and payment reminders for all bills. Payment history accounts for 35% of your credit score, so late payments can really hurt you. To prevent this, establish autopay for your bills. For accounts without autopay options, set a calendar alert a few days before their due date. Your credit score will rise if you consistently pay your accounts on time. (For the purpose of credit reporting, “on time” means paying within 30 days of the due date.)

  • Reduce your debts. Stop adding to your credit balances and start paying them down. The lower your credit utilization rate (how much of your total credit lines you’re using), the better your credit score – and your shot at getting a home equity loan. Most experts recommend a utilization rate of 30% or less. However, lower is always better.

  • Avoid new credit cards and loans: When you apply for a new card or loan, it triggers a hard credit inquiry.  According to Experian, each inquiry drops your score by up to 5 points.

Finally, keep your accounts open — even if you’ve paid them off fully. The average age of your credit comprises 15% of your score. And older is always better. 

Calculate your debt-to-income ratio and reduce it if possible.

In addition to your credit score, lenders also look at your DTI — your debt-to-income ratio. This number reflects how much of your income goes toward debt repayment and housing costs. 

Most lenders want a DTI of 43% or less, meaning your debts take up no more than 43% of your monthly income. You can determine yours by adding your monthly debt payments to your rent or mortgage payment, then dividing the total by your before-tax income. 

Here’s an example: Let’s say you owe $1,500 each month on rent, credit cards, student loan payments, and your car loan. Your monthly income is $4,000. To determine your DTI, it’d look like this: 1,500 / 4,000 = 0.375, or 37.5%. In this case, you’d have a DTI well under 43%, which would help you more easily qualify for a home equity loan, even with bad credit.

Determine your equity and loan-to-value ratio.

Having a low loan-to-value (LTV) ratio — meaning your loan amount is only a small percentage of your home’s value — can help you get a home equity loan with bad credit too.

Your LTV indicates how much home equity you have. You calculate it by dividing your current mortgage balance by your current property value. You can estimate your property value with an online tool from a real estate website. Understand that a mortgage lender will probably require a home appraisal before approving a loan

If your home value is $400,000, for example, and you owe $200,000 on your mortgage, you have a 50% LTV (200,000 / 400,000). 

Most home equity lenders set their maximum LTV at 80% to 90%. However, if you have bad credit, your limit will probably be lower. The less you borrow, the lower your LTV is, and the easier it will be to qualify.

If your lender is willing to approve a loan up to 75%, how much can you borrow? You find out by multiplying your home value by .75% and then subtracting your mortgage balance. For the example above, then, you multiply $400,000 * .75 to get $300,000. Subtract your $200,000 mortgage balance, and you get a home equity loan amount of $100,000.

Get a consigner.

Some mortgage programs allow borrowers with poor credit to qualify by adding cosigners with better credit.  If you have a family member with good credit, consider asking this person to cosign with you. Not only can it help you qualify for the loan, but it also may help you get a lower interest rate.

Understand that your cosigner will be liable for the loan balance if you fail to repay it. In addition, any late payments that land on your credit report will probably land on theirs as well, harming their score. Finally, cosigning creates contingent liability (the possibility that the other person might have to assume your obligation). This can hurt your cosigner’s ability to borrow in the future.

Compare a few different lender options.

A lower credit score typically translates to a higher interest rate on home equity loans — or any loans for that matter. Still, every lender has different policies and requirements, and home equity loan rates vary considerably among providers.

That’s why it’s essential to compare quotes from several lenders before choosing a home equity loan — particularly if you have a low credit score.

To do this, you’ll pick three to five lenders (ideally a mix of options, like a big bank, a credit union, an online lender, etc.), fill out their prequalification form, and get a rate quote from each one. They should give you a loan estimate form that you can use to compare rates and fees line by line from each company. Examine the monthly payment, the interest rate, the total cost over the life of the loan, and the origination fee.

Consider other financing alternatives.

There’s no guaranteed home equity loan for bad credit, so if you’re finding you can’t qualify, consider another financing option. 

Some alternatives you might think about include:

  • Cash-out refinancing: Cash-out refinancing involves replacing your current mortgage with a larger one and taking the difference in cash. If your credit scores are low, you might find it easier to get an FHA cash-out refinance than a home equity loan. 

  • Home equity line of credit: HELOCs are similar to home equity loans, but they work more like credit cards. They are no easier to get than home equity loans. However, HELOCs tend to have lower minimum loan amounts, so you might have an easier time getting approved for a small HELOC than a large home equity loan.

  • Non-prime home loans: Some mortgage leaders serve borrowers with lower credit scores. Expect to pay higher interest rates and closing costs.

  • Personal loans: Some personal loan providers have lower minimum credit scores than home equity lenders. They also offer fast funding, but interest rates can be quite high. 

With all of these options, shopping around is still critical. Check with a few lenders, carefully comparing the terms, rates, and fees before choosing a loan. You should also read customer reviews before applying. 

Work with a debt relief company or professional.

If your credit score is bad because you can’t afford your debts, talk to a credit counselor or debt relief professional. They may help you get on a debt management plan or negotiate a settlement to improve your financial situation going forward.

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