Even if you have a bad credit score, you stand a much better chance of getting approved for a home equity loan—but you'll put your home at risk.
When you have a bad credit score, your borrowing options are pretty limited. If you have an unexpected expense pop up—and you don’t have an emergency fund to cover it—you may not be able to take out a personal loan from a bank or take out a credit card to cover the cost.
But if you own your home, you might have another option available to you. That’s right, you could possibly qualify for a home equity loan or line of credit--even if your credit is poor. And while your lousy credit score will still raise the total cost of these home equity products, the overall price tag may be lower than the alternatives. Here’s what you need to know.
What is a home equity loan?
So you probably know what a home mortgage is: It’s a loan that you take out to purchase a house or condo that uses said house or condo as collateral. Well, home equity loans are similar to mortgages. They are also loans that are secured by the value of your home.
The difference between home equity loans and mortgages is that home equity loans are secured by the “equity” that you have in your home. And what’s equity? It’s the value of your home above and beyond what you still owe on your mortgage.
Let’s say that you bought a home for $300,000, and, after a couple of years, you still have $250,000 left on your mortgage. The amount of equity that you now own in your home is $50,000, and you own 20% of your home in total. The other 80% is technically owned by the bank until your mortgage is paid off entirely.
With a home equity loan, you could (in theory) borrow up to $50,000 against that equity. Of course, a lender will almost certainly not approve you for that full amount. In fact, they very rarely (if ever) lend more than 80% of a home’s equity value. With $50,000 in equity, that would mean a max loan amount of $40,000.
You could also try borrowing a home equity line of credit (HELOC) instead of a home equity loan. Unlike a loan, which gives you all your money at once, a line of credit lets you withdraw funds as you need—similar to a credit card. With a HELOC, you’ll only owe interest on the money you withdraw.
Taking out a home equity loan with bad credit.
Folks with bad credit and who need a loan are going to have trouble getting an unsecured personal loan from a traditional lender. That’s because your credit score is an incredibly important indicator as to whether or not you're likely to repay. A poor score tells traditional lenders that you pose much too high a risk to be worth lending to. (If you're considering taking out a bad credit loan, be sure to read our Ultimate Guide to Bad Credit Loans first!)
With secured loans, there’s collateral involved to reduce that risk. If you can’t repay, the lender can seize your collateral and sell it in order to make up their losses. Granted, this means the stake for taking out a secured loan—like an auto loan, mortgage, or home equity loan—are much higher. But it also means that you are more likely to be approved for one.
However, just because you can get approved for a home equity loan with bad credit doesn’t mean there aren’t drawbacks. For one, you are still less likely to be approved for a home equity loan or line of credit than you would be if you had a good score. Second, you’ll likely have to settle for a smaller loan amount and a higher interest rate plus possibly some additional fees.
No loan is ever without risk. Even an interest-free loan from a friend or family member can come with dire social consequences if you don’t pay it back. And while a home equity loan might be a lot easier to repay than a high-interest title loan, it still comes with the risk of losing your house if you go into default. It’s not a decision to be made lightly.
5 questions to ask yourself before borrowing.
If you have bad credit, you should consider all your options before taking out a home equity loan. Here are five important questions you should ask yourself:
- Do I need this money right now? If you’re considering this loan to pay for something that’s more of a “want” than a “need,” then you shouldn't apply for it. And if you’re using it to cover an emergency expense, take a look at all your repayment options. Maybe this is a charge that you can pay off in installments instead of borrowing money to pay it all upfront.
- Can I pay for this some other way? One of the building blocks of responsible personal finance is starting (and maintaining) a well-stocked emergency fund. Maybe, instead of borrowing money, you can dip into that fund and save yourself all the money you’d be putting towards fees and interest!
- How much do I need and how much can I afford? When you have a credit card, there’s little harm in agreeing to raise your total credit limit. (In fact, your score could benefit!) With a loan, however, you don’t want to borrow any more than you need. And you’ll also want to consider how the size of your loan will affect the size of your payments. You don’t want to end up paying more than your budget can handle.
- What’s the best deal I can find? Don’t just apply for the first home equity loan you see. Do your research. Ask for quotes and gather offers from all the different lenders you can find. Find reviews of them and check out their BBB pages to see how other customers have liked dealing with them. Basically, find the best loan—and lender—that you can.
- What can I do to improve my application? Go to www.AnnualCreditReport.com and request a free copy of your credit report from one of the three major credit bureaus. Read your report to see why your credit is bad and what you can do to improve it. And take a look at the rest of your financials, as well, to see where you can do better. The more attractive you seem to a lender, the more you’ll be able to borrow, and the less you’ll have to pay.
Walking around with a bad credit score will completely shut you out from a lot of traditional loans, but not from a home equity loan or line of credit. The question you should be asking yourself isn’t whether you can get the loan, but whether you should.