If you’re grappling with a bad credit score and have a troublesome credit history, you know getting approved for a loan can be a challenge. Yet, as a homeowner, you’ve also likely been flooded with refinancing and home equity loan offers over the years from companies eager to lend funds in return for a stake in your property.
A home equity loan can be critical to fund a renovation, education, new business venture, or just to escape pressing credit card debt. While there are limits on how low a score lenders will accept, there are steps you can take to secure a home equity loan with bad credit.
What Is a Home Equity Loan?
Mortgage payments are generally the biggest portion of monthly housing costs. But this money isn’t just the price for a roof over your head at the moment—it’s an investment that grows over time.
“Equity” is how much of your property you own compared to what your mortgage lender still owns. As time goes by, your slice grows bigger and the lender’s slice slims down.
A home equity loan is a secured loan that uses your equity as security, allowing you to get a lower interest rate than you would with an unsecured personal loan or credit card. The flip side to that benefit, however, is the risk of foreclosure. If you can’t make your loan repayments, the lender can repossess your home.
Home equity loans:
- Can last for typically five to 20 years, with some lends offering loan terms up to 30 years1
- Allow you to borrow up to about 80% of your equity
- Take your creditworthiness into account even though your house is put up as security
The Impact of Bad Credit on Home Equity Loans
A low credit score can result in either a denied home equity loan or an offer with an uncomfortably high interest rate.
What credit score do you need to have to get a home equity loan? The minimum credit score is set by each lender, but here’s a general breakdown of credit scoring:
- 579 or lower: Bad credit, unlikely to be approved for a traditional loan2
- 580 to 639: Poor credit, may need to negotiate and will be offered a higher interest rate
- 640 to 699: Fair credit, can aim to hit the average rate of 8.3% (as of June, 2023)3
- 700 to 749: Good credit, likely to receive good terms
- 750 and up: Excellent credit, likely to receive the best rates available
For the most part, 620 is the minimum credit score to qualify for a home equity loan with a reputable lender.1
Steps to Secure a Home Equity Loan with Bad Credit
For borrowers with bad credit, there are few overarching principles to follow: improve your credit score in steps within set timeframes; understand what factors are taken into account; and shop around for the best lender for your circumstances.
To help, here are the specific steps broken down:
Review Your Credit Report
The first step to getting a loan with bad credit is to see what you can do about your credit score. You can increase a low score by up to 100 points with the following steps, some of which will yield results in as little as one month.4
Change your habits:
- Pay bills on time
- Pay down credit card debt and balances to no more than 30% of your limit (the lower the better)
- Make multiple small payments instead of one large monthly payment for credit cards
Clean up your report:
- When your accounts are current, ask creditors to stop reporting missed prior payments
- Identify errors on your report and dispute them
- Ask for any collections accounts older than seven years to be removed from your history
- Negotiate with collections to pay off claims and get them to stop reporting them
- Use Experian Boost or a rent reporting service to get credit for paying rent and bills
Increase your unused credit amount:
- Call credit card carriers and ask if you can get a higher limit
- Ask high-scoring friends to add you as an authorized user to a credit card
- Open a secured credit card backed by a cash deposit
Calculate Your Equity and Loan-to-Value Ratio
Home equity refers to how much of your property you own, often expressed as a dollar amount. You can estimate it using a loose valuation of your house using an online calculator and subtracting what you currently owe. For example, if Toby’s house is valued at $400,000 and he owes $275,000 on his mortgage, then he has $125,000 in home equity.
Lenders use the more specific loan-to-value (LTV) ratio to identify the status of ownership and value expressed as a percentage. To determine LTV ratio, divide your loan balance by the value of your home (most lenders require valuation by a licensed professional appraiser). Note:
- Loan balance includes mortgage plus current home equity loans, HELOCs, and liens
- Include the principal balance of your loans (vs. a pay-off amount that includes interest)
- Use the full limit of a HELOC in its draw period or the balance if in repayment
For example, if Sheila’s home is appraised at $240,000 and she owes $140,000 on her first mortgage plus a tax lien of $20,000 on it, then her LTV is:
(140,000 + 20,000) ÷ 240,000 = 0.67, or 67%.
Combined LTV (or CLTV) adds the loan amount you want to borrow to what you currently owe. If Sheila applies for a $30,000 home equity loan, then her CLTV will be 79% (190,000 ÷ 240,000 = 0.79), an amount satisfactory to most lenders.
Traditional lenders may allow for a higher CLTV, but if you’re applying with bad credit, plan on a maximum of 80% or lower for your loan.2
Understand Your Debt-to-Income Ratio
How does your monthly income compare to your current debt obligations? Lenders look for a debt-to-income ratio of 43% or less for home equity loans, but you may need to come in significantly lower on that calculation to counterbalance a poor credit score.5
To calculate DTI, divide your total monthly debt payments by your gross (pre-tax) monthly income. Debt payments don’t include routine ongoing cost-of-living items like groceries, gas, or utilities; instead, include how much is due each month for:
- Mortgage and any other loans against your property
- Auto loans
- Credit card and personal loan payments
- Student loans
- Accounts in collections
Find a Lender that Accepts Lower Credit Scores
Regardless of your current circumstances, keep this as a lifelong rule: shop around before you commit to any loan. There are lenders who specialize in types of loans, niche real estate, and—yes—borrowers with problematic credit histories.
Write a Personal Statement
Include an honest, concise note with your application to help the loan officer or lender understand how you’ll avoid repeating past mistakes. This might include:
- Contributing circumstances such as health, divorce, or job loss
- A debt consolidation and repayment plan
- A monthly budget
- Work with a credit counselor
Consider Alternatives to Home Equity Loans
Traditional home equity loans aren’t the only option available to homeowners in need of a cash infusion. Look into these alternatives:
- Co-signed home equity loan
- Home equity sharing
- Cash-out refinance
- Home equity line of credit (HELOC)
- Low-interest credit card
- Reverse mortgage if you’re 62 or older
- Sale-leaseback program
While not a direct alternative to a home equity loan, another loan option to consider is the FHA loan. There are different types of FHA loans, and they are government-backed loans that are designed to help low- and moderate-income borrowers buy homes. FHA loans have lower down payment requirements and more flexible credit score requirements than conventional loans, making them a good option for borrowers who may not qualify for a conventional mortgage.6 While FHA loans do not offer conventional home equity loans, they do offer a cash-out refinance option that allows borrowers to tap into their home equity.7 Read more on how to get an FHA loan with bad credit with our guide.
Exploring Sale-Leasebacks as an Alternative
Residential sale-leasebacks pair the sale of your home with a leaseback contract. Similar to a rental agreement, the contract will identify your monthly rent amount and general terms of occupancy, but it can also:
- Legally guarantee your right to remain in the home as a renter for as long as you want
- Lock in the rental rate for a period of years
- Limit future rent increases
Depending on your current mortgage payments, switching to renter status may allow you to reduce your monthly housing cost—plus you’ll spend less time and stress on your home. You’ll no longer be responsible for:
- Property tax
- Homeowners insurance
- Covered repairs and maintenance
How Sale-Leasebacks Can Be a Viable Alternative to Home Equity Loans
If you’re hoping to pass a family home down through the ages, then selling may not be for you. But a sale-leaseback may be right for you if your primary goals are to:
- Obtain a significant lump sum of cash
- Remain in your current home
You can accomplish both of these via a sale-leaseback with a reputable owner-investor.
The Benefits of Sale-Leasebacks for Homeowners with Bad Credit
Just as with a traditional sale, your credit history is largely irrelevant to closing on a sale-leaseback. There is no debt to repay, so there is no underwriter judging your creditworthiness based on past actions or credit score.
You can secure a home equity loan with a credit score as low as 620, though you may need to offset that with other factors such as reducing your DTI ratio.
Before you commit to a loan, take steps to improve your credit score—some of which can take effect in as little as 30 days. Shop around and compare mortgage lenders and be sure you understand how your CLTV, DTI, and credit score can affect loan terms.
Before applying for a home equity loan, consider alternatives. If taking on new debt, particularly one with a high interest rate, isn’t the right course for you, a sale-leaseback can convert your equity to cash while you continue living in your home.
This article is published for educational and informational purposes only. This content is based on research and/or other relevant articles and contains trusted sources, but does not express the concerns of EasyKnock. Our goal at EasyKnock is to provide readers with up-to-date and objective resources on real estate and mortgage-related topics. Our content is written by experienced contributors in the finance and real-estate space and all articles undergo an in-depth review process.
- NerdWallet. Getting a Home Equity Loan in 2023: What It Is and How It Works. https://www.nerdwallet.com/article/mortgages/home-equity-loan
- Credible. Have Bad Credit and Want a Home Equity Loan? Here’s What to Do. https://www.credible.com/blog/mortgages/home-equity-loan-bad-credit/
- Bankrate. Current home equity interest rates. https://www.bankrate.com/home-equity/current-interest-rates/
- NerdWallet. How to Improve Credit Fast. https://www.nerdwallet.com/article/finance/raise-credit-score-fast
- NerdWallet. Requirements for a Home Equity Loan and HELOC. https://www.nerdwallet.com/article/mortgages/what-are-the-requirements-for-a-home-equity-loan-and-heloc
- MorgageLoan.com. Complete guide to FHA Mortgage Loans. https://www.mortgageloan.com/fha
- FHA.com. Is There an FHA Home Equity Line of Credit?. https://www.fha.com/fha_article?id=3446