A home equity loan is a worthwhile option if you are a homeowner and need a lump sum of cash. These loans offer competitive rates compared to credit cards and personal loans, and you may qualify for a tax deduction. But can you get a home equity loan and get these benefits if your credit score is bad? It depends.
A home equity loan is a type of second mortgage. Home equity loans allow you to borrow against the equity you have built in your home.
Traditional banks, credit unions, and online companies can be home equity loan lenders. Most limit the amount you can borrow to 85% of your home’s equity.
To illustrate how a home equity loan works, assume your home is worth $390,000 and you still owe $245,000 on your mortgage. If you qualify for a home equity loan, you could access up to $86,500 in financing.
Because? Because 85% of the value of your home ($390,000) equals $331,500. Next, subtract the outstanding balance on your mortgage ($245,000). The result is $86,500, which is the maximum amount the lender will allow you to borrow. We break it down here:
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$390,000 x 0.85 = $331,500
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$331,500 – $245,000 = $86,500
Lenders disburse the funds in a lump sum, payable in equal monthly installments over a period of 5 to 30 years. Home equity loans also have lower interest rates than many other loans and revolving credit products; Those rates are also fixed, making monthly planning and budgeting easier. And if you use the funds to purchase, build, or substantially improve your primary residence, you may be eligible to deduct the interest paid on the home equity loan from your taxes.
However, there are some disadvantages and risks to consider. A home equity loan is a second mortgage that uses your home as collateral. Therefore, if you can’t afford the monthly payments, you could lose your home to foreclosure. You will also pay upfront closing costs between 2% and 5% of the loan, and withdrawing funds reduces the amount of home equity you have.
A lower credit score isn’t necessarily a deal-breaker if there are other compensating factors, such as a low debt-to-income (DTI) ratio, high income, or sizable cash reserves, to increase your chances of approval.
FICO classifies a bad or “poor” credit score as any three-digit number below 580. In case you’re interested in a more detailed breakdown, here’s how credit scores are classified:
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Poor: 300-579
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Fair: 580-669
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Good: 670-739
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Very good: 740-799
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Exceptional: 80-850
Many lenders prefer a minimum credit score of 680 for a home equity loan. However, remember that it is not always necessary to have a “good” credit score to qualify for financing. Some home equity loan lenders are more flexible than others and will approve you with a score as low as 620.
That said, if your score falls below this threshold, qualifying will be difficult. If you find a lender willing to give you a loan, expect less favorable loan terms, such as a higher interest rate. In this case, you’re probably better off waiting until your score improves to apply, unless you get a cosigner.
These steps will help you navigate the process with confidence:
1. Understand the lending guidelines
The requirements for home equity loans are similar to those for a first mortgage. Most lenders have guidelines regarding your credit score, combined loan-to-value (CLTV) ratio, and DTI ratio limits.
It is common for lenders to require a maximum DTI ratio of 43% and a CLTV ratio of 85%.
When you’re ready to apply, contact the lenders you’re considering to learn more about what they look for when reviewing home equity loan applications. That way, you can ask questions, know what to expect, and avoid surprises.
2. Improve your credit score and debt levels
It is essential to review your credit report, especially if your score is on the lower end. The information from your credit report is used to calculate your credit score. Therefore, you want to confirm that the report is free of errors that could be affecting your credit score.
If you spot inaccuracies, file credit report disputes immediately for resolution. You can dispute errors with creditors directly or start the process through the credit bureaus by mail, phone, or online.
It’s equally important to avoid opening new lines of credit during the application process, because doing so will affect your credit score. And, if possible, pay off your credit cards or other loans to lower your credit utilization ratio and improve your credit score.
Paying off debt will also improve your DTI ratio, which reflects the percentage of your income allocated to monthly debt obligations. To calculate this figure, add up all of your required monthly debt payments and divide this figure by your gross monthly income (before taxes). Then, multiply the number by 100.
For example, if your minimum monthly debt obligation is $4,500 and you earn $11,000 before taxes, your DTI ratio is 41%, which is below the recommended threshold of 43%.
Again, lenders also consider another factor: your combined loan-to-value (CLTV) ratio, which includes the loan proceeds over your home’s equity. You should not exceed 85% to qualify for a home equity loan, hence the importance of having sufficient capital before applying for financing.
Using the example above, if you owe $245,000 on a home valued at $390,000, your LTV ratio would be approximately 63%:
$245,000 / $390,000
If you withdraw $80,500, your CLTV ratio would be 83%:
($245,000 + $80,500) / $390,000)
Don’t settle for the first home equity loan lender you find on Google. Instead, do your homework and check out at least three lenders you’re interested in.
Get pre-qualified and compare loan quotes to make an informed decision about which is best for your financial situation. This process is usually quick and does not involve a strict credit check. Keep in mind that the numbers you receive from a prequalification are only estimates. You’ll need to apply for a mortgage pre-approval, which requires a thorough credit check, to get a more detailed estimate.
Before submitting a formal application to your chosen lender, organize the documents you will need to process your application, such as employment information and tax records. Doing so can help avoid hiccups in the loan process.
If approved, pay attention to closing costs, prepayment penalties (if applicable), and other fees associated with the loan.
It depends on your financial situation. If you’ve exhausted other options, a home equity loan might make sense even if your credit score is low. However, if your credit score is too low to qualify or would result in less favorable loan terms, a personal loan or credit card may be a better option. Still, make sure you can afford the monthly payments on any type of loan you take out.
A credit score of 620 is typically the lowest most lenders go. However, a stronger credit score generally means more competitive rates and lower borrowing costs.
If a lender rejects your home equity loan application, contact us immediately to discuss the rejection further. Doing so will give you a deep understanding of what they’re looking for, so you’ll know what areas to improve before you apply again. Another option is to reapply with a mortgage cosigner who has a strong credit rating. Keep in mind that they will assume responsibility for your home equity loan payments if you fall behind.
Laura Grace Tarpley Edited this article.