Home equity loans can help you unlock extra value in your home. By borrowing money against your property, you can finance home repairs and renovations, which can increase its value. You can also use the money to cope with financial emergencies, or even to pay off debt.
That’s because home equity loans and home equity lines of credit — the two most common forms of borrowing against a home — tend to have much lower interest rates than debt not guaranteed by real estate, like credit cards.
“Utilizing a relatively low-interest loan, especially if it is to cover the cost of a major home improvement or renovation, could be a smart financial move,” Elliot Pepper, CPA, CFP and co-founder of Northbrook Financial, told us.
But being a homeowner is not the only requisite to borrow against real estate.
First, you need to have what the name of those loans implies: home equity. You are borrowing against the value of the stake you hold in your property, i.e. your home equity — so you need to owe less on your mortgage than the house is worth. If your house is appraised at $300,000 and you owe $100,000 on the mortgage, you have $200,000 in home equity.
The more equity you have in your home, the more money you’ll be able to borrow, all other factors being equal — up to a maximum of 85%. That amount is determined by factors including your income and creditworthiness, as well as the value of the property.
Second, that creditworthiness — as expressed by your credit score — and your income must be sufficient for a lender to decide that you can borrow money responsibly. The minimum credit score required to apply for a home equity loan is 620 for most lenders; you’ll see the best interest rates above 720.
How Your Credit Score Plays a Role in Getting a Home Equity Loan
You should familiarize yourself with credit score ranges, so you can see where you stand:
Credit Score Ranges
|CREDIT SCORE||CREDIT RATING|
Under 720, you’ll likely still qualify for a home equity loan or be able to refinance an existing one, says Travis Tracy, a Certified Financial Planner at Fortitude Financial Planning. But once your credit score is below that threshold, things start to look a little murkier.
Can you get a home equity loan with bad credit? And, should you?
What to Do If You Have Bad Credit
“If you plan to secure a home equity loan and have at least the 15 to 20% equity required, but you have bad credit, you should take steps to improve your credit score first,” says Lindsay Martinez, owner and financial planner at Xennial Planning.
She recommends downloading your credit reports from each of the three major agencies — Equifax, Transunion and Experian — and ensuring there aren’t any inaccuracies which might affect your score negatively. If there are, she suggests taking immediate steps to dispute them with the credit agency, and correct them. (A credit report isn’t a credit score; those are different things, although the former influences the latter, which is viewable for free in many credit card online accounts.)
“Sometimes things that you have rectified haven’t fallen off your report yet, so it might be impacting your score,” Tracy says. You can get a free copy of your reports from each one of the three agencies, once a year, at annualcreditreport.com.
It’s also a good idea to take a look at your budget and your spending habits.
Not paying off your credit card balances in full each month will raise your credit utilization ratio, which lowers your score. Addressing the root of the problem can help narrow down steps you might want to take to rectify it.
Martinez also advises against applying for additional credit, since each application will result in a temporary hit of a few points to your score, or missing any debt payments. Missing bill payments will affect your credit negatively, as well.
“Having steady employment over many years and/or a high income can help your chances” of getting approved for a home equity loan with low credit, Martinez says. A high income can also improve your debt-to-income ratio, which most lenders like to see lower than 43%, she says.
If you want to proceed, Tracy recommends checking with your current lender to see if they’d be willing to work with you. Already having a mortgage that you’re paying on time might suggest to the bank that you are a trustworthy borrower.
Whatever you choose to do, there’s one thing experts strongly advise against: using home equity to fund personal expenses, such as a vacation or fancy new car.
Borrowing against your residence means putting it up as collateral; if you stop paying the lender, that residence can be seized. Running that risk in order to fund personal spending is not a smart financial decision.
Getting a home equity loan with bad credit is challenging, but not impossible. Having a low debt-to-income ratio, and a solid employment history, may help offset a low credit score in the eyes of a potential lender.
But what you want to ask yourself is whether you need that loan now. Credit scores are not fixed, so the best way to proceed might be to reassess your spending habits and wait until you can raise your credit score. This will help you not only get the loan, but get it at a much better interest rate.