Bad credit can get in the way of a lot. When it comes to tapping into equity, it can make things feel harder. When looking at the different home equity loans, it becomes apparent that bad credit and a high debt-to-income ratio remove several options from the table.
When a borrower has bad credit but still has adequate equity to qualify for refinancing, they will likely qualify for a bad credit home equity loan. Bad credit can limit someone’s options, but the home equity loan marketplace is diverse. It’s normally possible to qualify for a loan, even if you have bad credit.
The experience of seeking a home equity loan with bad credit isn’t quite the same as with good credit. While securing a loan is still plausible, there are a few differences that prospective borrowers may want to keep in mind.
Qualifying For A Home Equity Loan With Bad Credit?
Lenders are primarily concerned with risk. They want to deal with people they view as less risky. When they deal with borrowers who are considered high-risk, they will seek to offset that risk through rates, terms, collateral, and other loan factors.
There are no regulations stating absolute minimums to qualify for a home equity loan. But there are a few qualifications for home equity loans with bad credit:
- At least 15 percent to 20 percent equity in your home.
- The loan does not exceed 85% of the home’s value.
- A credit score that reaches a lender’s minimum threshold (Bad credit lenders normally set absolute minimums of 500; below 620 is considered bad credit; there are some exceptions)
- A maximum debt-to-income ratio of 43 percent (up to 50 percent for some lenders)
- Stable employment and income history.
How to Apply for a Bad Credit Home Equity Loan?
Those who want to apply for a bad credit home equity loan may follow these steps to make a formal application:
Step 1: Check your credit report & improve it
Before seeking a bad credit loan, borrowers can order a free credit report from one of the 3 major credit bureaus. The credit report will paint a complete picture of the borrower's credit score. Credit reports list out every credit transaction that goes into the credit score. This way, borrowers can see exactly why their score is what it is.
In some cases, borrowers decide to improve their score before applying for a home equity loan. This can help them secure better rates and terms. In some cases, borrowers notice errors in their credit reports. It’s easy and free to report an erroneous entry on a credit report. Having a negative, erroneous entry corrected can also improve the borrowers’ credit score.
Step 2: Evaluate your debt-to-income ratio
The debt-to-income ratio is meant to measure each loan applicant’s total debt balance with their income. It is a simple, percentage-based metric that represents another risk of lending. For example, if you have an income of $80,000 and have a total of $20,000 in debt, your debt-to-income ratio is 25%.
The main benchmark for a debt-to-income ratio is 43%. A ratio any higher than that will be considered high-risk to the point that many lenders would reject the borrower’s application. Some lenders will loan money to those with a ratio of up to 50%, though.
Paying off debt is the only way to reduce a debt-to-income ratio. If possible, some borrowers may opt to lower their debt-to-income ratio before seeking loans. As in step 1, this may broaden the borrower’s options.
Step 3: Find out how much equity you have on your home
Home equity is the fair market value of your home divided by the principal balance of your mortgage. For example, if your home is worth $400,000 and you owe $300,000 in mortgage principal, you have 25% equity in your home.
For borrowers seeking a home equity loan, knowing the equity they have in their home, both as a figure and a percentage, is important. Lenders are happier to deal with people who have more equity. However, the percentage of equity is important in evaluating the risk of the loan.
It’s usually considered better practice to seek a home equity loan when the borrower’s equity in their home is stronger.
Step 4: Consider how much you need
Even when all the above factors are strong for a borrower, it doesn’t pay to borrow more than one needs. Borrowers can be more successful with loans by carefully considering the cost of their expenses and borrowing accordingly. Then, the borrower can cover the entire intended cost of an expense while being prepared to pay the loan back.
Step 5: Compare interest rates
A home equity loan’s interest rate is the most significant factor in determining its cost. Loans can have several closing costs and other costs. However, those are normally far less significant than the interest rate. The interest rate of a home equity loan is the percentage that the borrower must pay back in order to take the loan. Interest is paid back first, followed by the loan’s principal.
Comparing interest rates and getting the best rate possible (given the borrower’s creditworthiness) is one way to potentially save money. An interest rate that is just half a percent lower can easily equal hundreds of dollars for home loan products.
Step 6: Use a co-signer
Borrowers with bad credit can put themselves in a better position to borrow by finding a cosigner. A cosigner is someone who lends their creditworthiness by serving as the guarantor for a loan. Of course, the cosigner will be made to understand the risks in guaranteeing a borrower’s loan before cosigning.
For a cosigner to save a borrower more money, it may be easier if they have a high credit score, a stable income, and other markers of creditworthiness.
Step 7: Boost your credit
Borrowers can prepare for the loan comparison and application processes by first boosting their credit. Borrowers can boost their credit over the course of a few months by:
- Checking their credit report
- Paying their bills on time each month
- Not closing credit cards after paying them off
- Not maxing out or opening new credit cards
- Paying down credit card debt
Can You Get a Home Equity Line Of Credit (HELOC) With Bad Credit?
Yes, you can also get a HELOC with bad credit. For some borrowers’ needs, a HELOC may be the preferable option.
What is a HELOC?
A home equity line of credit (HELOC) is a rotating credit product. Like a home equity loan, they are secured by the equity in the borrower’s home. The difference is simply how the funds are dispersed and how they are repaid.
With a HELOC, borrowers are given a maximum credit limit instead of a specified lump sum. Borrowers can draw as much as they need from their line of credit. They can also draw as many times as they need, making it a commonly preferred option for borrowers who:
- Don’t know exactly how much money they will need
- Need to cover ongoing expenses which may require many separate payments
HELOCs come in two periods:
- A “draw” period where they may draw funds as much as they need, as long as they don’t exceed their credit limit. During the draw period, only interest repayments are required when funds are drawn.
- A “repayment” period, where the borrower must repay both the interest and principal of any funds that have been drawn.
Risks of HELOCs With Bad Credit
HELOCs carry similar risks to other loans. Like home equity loans, the borrower also puts their home at risk if they can’t repay the debt.
In the above way, HELOCs share the same risks as other collateralized loans, especially home equity loans. But they also have the added consideration of sudden increases in repayment requirements. During the draw period, repayments are typically small. HELOCs actually come with lower interest rates than most other loans, on average. So, when the repayment period begins, having to pay back both interest and principal increases the repayment costs significantly.
Borrowers should be prepared for the increased costs that are incurred when a HELOC repayment period begins.
Home Equity Alternatives For Bad Credit
There are several alternatives to home equity loans for borrowers with bad credit:
Personal loans are a common alternative for those who do not want to use their home’s equity as collateral. Securing a loan with equity helps reduce the cost of a loan. However, it adds an element of risk that some people would rather avoid.
Personal loans do not require home equity as collateral. Requirements can vary significantly from lender to lender. Likewise, borrower creditworthiness will influence the rates, terms, and collateral requirements for a personal loan. With bad credit, usually, borrowers may find higher interest rates and potential collateral requirements.
A cash-out refinance is another mortgage option. In this case, an old mortgage would be replaced by a newer, larger loan than what is left of the original mortgage. This is normally used by borrowers who want to use their first mortgage to get some cash.
People seeking home equity loans don’t need to be dismayed by their bad credit. There are still plenty of options for borrowers with bad credit. Where the borrower finds it more agreeable, they can also seek out alternative forms of financing.
Borrowers can improve their creditworthiness before seeking loans. This may help them qualify for better rates and terms.