A home equity loan lets you borrow money using the value of your home as collateral. It allows you to access money for home improvements, debt consolidation and other large expenses. However, having a low credit score can make getting a loan challenging, and pricier.
Below, we’ll explore how to get a home equity loan with bad credit, steps to improve your credit score and alternative options to consider.
Paying off debt can feel like an endless struggle especially when you have bad credit. High interest rates make it difficult to make headway on credit cards personal loans, and other debt. However, a home equity loan can provide a powerful tool to consolidate and pay off debt once and for all.
As the owner of this personal finance blog, I want to explain how home equity loans work, their requirements, whether they make sense for borrowers with lower credit scores, and tips for improving your chances of approval. My goal is to educate readers on how to use home equity wisely to escape the debt trap.
What is a Home Equity Loan?
A home equity loan lets homeowners borrow against the equity in their home Equity is the current market value of your home minus what you owe on your mortgage For example, if your home is worth $300,000 and you owe $180,000 on your mortgage, you have $120,000 in equity ($300k – $180k = $120k).
With a home equity loan, you can tap into this equity and receive funds in a lump sum. The loan has a fixed interest rate and a fixed monthly payment, usually over a repayment term of 5-30 years.
The benefits of a home equity loan include
- Access to large loan amounts based on your equity
- Potentially lower interest rates than credit cards or personal loans
- Fixed monthly payments that help simplify budgeting
The downsides are that you put your home at risk if you default, and interest rates are higher than rates for first mortgages.
Requirements for Home Equity Loans
While home equity loans have stricter eligibility standards than unsecured loans, they are attainable even with fair credit (scores in the 620-679 range). Here are some common requirements:
- Credit score: 620 is typically the minimum, but scores of 680+ get better rates.
- Loan-to-value (LTV): Lenders allow combined loan amounts up to 80-90% of the home’s value.
- Debt-to-income ratio: 43-50% is typical. Lower is better.
- Equity: You usually need at least 15-20% equity.
- Mortgage history: On-time mortgage payments help approval chances.
Pre-qualifying lets you see potential loan amounts and rates without a hard credit check. This helps assess whether a home equity loan makes sense for your situation.
How to Improve Your Chances of Getting Approved
Even if your credit score falls short of excellent, there are ways to boost your odds of getting approved:
- Apply with a lender you already have a relationship with, like your bank.
- Bring on a cosigner with higher credit scores to strengthen the application.
- Write a letter explaining past credit issues and your plans to repay the home equity loan.
- Reduce your debt-to-income ratio by paying down debts.
- Build additional home equity by making extra mortgage payments.
I also recommend checking your credit reports for errors before applying. Getting any mistakes corrected can quickly give your score a boost.
When Home Equity Loans Beat High-Interest Debt
The wise way to use a home equity loan is to pay off more expensive debts, thereby reducing your overall interest costs. This debt consolidation strategy works well when you can qualify for a home equity loan rate that’s lower than your current debts.
For example, let’s say you have $15,000 in credit card debt at a 19% interest rate. You take out a $15,000 home equity loan at 7% interest to pay off the cards. Your new monthly payment would be about $225 instead of $388 on the credit cards. That’s over $150 in monthly savings you can apply toward paying off the home equity loan faster.
However, it’s risky to trade unsecured debt for secured debt tied to your home’s equity. Defaulting on a home equity loan risks foreclosure. If you’ve struggled with debt repayment in the past, adding more may do more harm than good.
Alternatives If You Don’t Qualify for a Home Equity Loan
If your credit or home equity needs improvement before getting approved, here are some other options to consider:
- Debt management plan: Work with a credit counseling agency to consolidate debts into one payment.
- Balance transfer card: Transfer credit card balances to a card with a 0% intro APR.
- Debt settlement: Negotiate with creditors to settle debts at a discount. High impact to credit.
- Cash-out refinance: Take cash from a new mortgage to pay off debts.
- Reverse mortgage: Borrow against home equity without repayment until you move. For ages 62+.
I always recommend speaking to a financial advisor to review the pros and cons of these alternatives for your unique situation. The right solution comes down to your credit profile, income, existing debts, and financial goals.
Tips for Improving Your Credit Score
If a home equity loan doesn’t seem feasible right now due to your credit, the good news is scores can rebound with some effort over time. Here are my top tips for credit repair:
- Review credit reports and dispute any errors you find.
- Pay all bills on time each month. Even one late payment can hurt.
- Pay down credit card and loan balances. Owing less helps your credit utilization ratio.
- Don’t close old credit cards as it reduces your total limit.
- Limit hard inquiries by only applying for credit when needed.
- Ask creditors to report your on-time payments to credit bureaus.
- Sign up for credit monitoring to stay on top of changes.
With diligence and patience, it’s realistic to improve your credit score by 50-100 points or more within 12 months. Once your credit profile strengthens, revisiting a home equity loan could make sense to consolidate high-rate debts.
Using Home Equity Wisely
As the owner of this personal finance site, my mission is helping readers use financial products strategically and responsibly. While tempting, tapping home equity should not be taken lightly, especially if you have existing troubles with debt or credit.
Home Equity Line of Credit (HELOC)
Similar to a credit card, a HELOC is a revolving credit line you can draw money from as needed. While the requirements might be more flexible than a standard home loan, interest rates can vary since they’re often adjustable. This means your payments could increase over time.
Cash-out refinancing lets you refinance your current mortgage to a larger amount than you owe. You receive the difference in cash to use however you want. It can be a good option if mortgage rates are currently lower than your existing rate. But refinancing often extends the life of your loan, which means you could pay more interest over time.
A personal loan is an alternative that doesn’t leverage your home’s equity. It’s unsecured, so you don’t have to provide collateral. You can get a personal loan relatively quickly, but often at higher interest rates, especially if you have bad credit. These loans have fixed monthly payments and a set repayment term, making them more predictable than HELOCs.
Tips for Improving Your Credit Score
Your credit score plays a big role when it comes to getting approved for a home equity loan. A better score can get you lower interest rates and save you money in the long run. To enhance your chances of approval, it’s wise to work on building a good credit score.
- Pay your bills on time: Your payment history makes up a huge part of your score, so timely payments can have a positive impact
- Keep an eye on your credit card balances: Reducing your credit utilization (that is, the amount you owe compared to your credit limits) can give your score a boost
- Lower your debt-to-income ratio: This measurement compares your monthly debt payments to your monthly gross income. To improve this ratio, pay down your debts such as credit card balances, avoid taking on new debts and consider ways to boost your income
- Review your credit report for any errors: Mistakes can drag your score down, but the good news is that you can dispute them. Everyone is entitled to a free credit report from each of the major credit bureaus: Experian, TransUnion and Equifax. You can get these through annualcreditreport.com. Grab yours, review it carefully and address any discrepancies you find