The main qualification for a home equity loan is having equity (ownership) in your home. But almost as important is having a good credit score. A poor score below a lender’s average may not necessarily disqualify you from taking out this type of loan, but it could make it more difficult to land one. You’ll want to be prepared to obtain a home equity loan with bad credit by keeping some considerations in mind.
Credit Requirements for Home Equity Loans
The first step in home equity loan eligibility is straightforward: You need to have at least 20% equity. Home equity is defined as the difference between what you owe on your mortgage and how much you’d get if you sold the house. Your credit score plays a significant role in whether lenders will approve you for a loan because a weaker score could signal a risky transaction. A lender will typically want to see a score of around 700, but it’s possible to find lenders who would work with potential borrowers in the 660 to 700 range. Lenders weigh other financial factors more significantly when your score is below 700. Having more equity, a lower debt-to-income (DTI) ratio, and a smaller credit utilization ratio could all tip the scales in your favor.
How Credit Scores Impact Interest Rates
A home equity loan is a fixed-rate loan secured by the value of your home. The fixed rate offered can significantly change, depending on your credit score and other factors reviewed by the lender. These include your full credit history, home equity, and lender requirements. Your unique combination of factors could mean paying thousands of dollars more per year in interest if you have a lower credit score. These are typical interest rates correlated with scores assigned by credit scoring company FICO. Note how much rates increase based on a low score.
Check Your Credit
The Fair Credit Reporting Act gives you the right to receive a free copy of your credit report once every 12 months. Lenders use reports to review where your credit stands when you apply for funding. You’ll want to know the details in the report, check for errors, and be prepared to answer any questions that lenders may have about it. You can order your free, yearly report at AnnualCreditReport.com. You also should stay updated on your credit score by using resources offered by your bank, free credit scoring websites, or even apps such as Mint or Credit Karma.
Assess Your Equity
The loan-to-value (LTV) ratio is how lenders assess your equity based on how much you owe on your mortgage. On average, your LTV should be 80% or less. This means that you have at least 20% equity in your home. But those with lower credit scores may want to showcase higher equity.
Look at Your Debt-to-Income Ratio
Your DTI ratio represents the total debt payments you make per month as a percentage of your monthly income. Most lenders look for 43% DTI or less for granting a home equity loan, but you should be below that level if you have a poor credit score. It gives lenders more confidence that you’ll prioritize your loan payments.
Write a Letter Explaining Your Credit Score
Lenders want to know that you’re trustworthy, and having more equity in your home boosts that confidence. But being prepared to address lenders’ concerns about a low credit score is another solid way to show that motivation. Be proactive in providing a letter to explain your credit history, current score, and actions you’re taking to build your credit.
Apply With Multiple Lenders
Shopping around for a loan with multiple lenders is a smart move, regardless of your credit score. Each lender will have different terms and conditions, such as annual percentage rate (APR), possible prepayment penalties, and credit insurance needs. Apply with several lenders you trust and have them compete for your business to get more favorable terms.
Alternatives to Home Equity Loans for Borrowers With Bad Credit
You may find that taking out a home equity loan isn’t the best idea with a poor credit score. There are other options to consider based on your financial outlook:
HELOC: A home equity line of credit (HELOC) acts like a credit card secured by your home. You can obtain as much money as you need within the draw period. Rates are variable, but you only pay for what you borrow. Personal loans: Personal loans are unsecured and can be used for almost any purpose. These tend to come with less favorable terms, such as higher APRs based on credit scores. You should still shop around to contend with your weaker score. Cash-out refinance: This pays off your first mortgage with a new, larger mortgage with different terms and timelines. The amount of your home equity decreases, but you may find it easier to find a lender that would accept a lower credit score in this scenario. Reverse mortgage: A reverse mortgage converts older owners’ home equity into payments from lenders that are, essentially, buying out your ownership.
The Bottom Line
A home equity loan is a good option for a financial boost to cover emergency expenses, starting a business, or doing a home renovation. Having poor credit doesn’t necessarily deny you this opportunity but prepare to pay a higher rate, hold more equity in your home, and work harder to convince lenders that you’re a good risk. You may want to pause the endeavor if you aren’t happy with the loan options you obtain with your credit score. Take the time to focus on improving your score instead, and pay special attention to your credit utilization, DTI, and the number of open accounts you have. Paying off debt, contacting creditors for support, and avoiding new purchases will all make you more attractive for a home equity loan. Want to read more content like this? Sign up for The Balance’s newsletter for daily insights, analysis, and financial tips, all delivered straight to your inbox every morning!
