A home can be a place of safety, comfort and wonderful memories. But your home — or, rather, the equity you’ve built up in your home — can also be a powerful asset that you can tap in times of financial need.
The difference between the money you owe on your home and the home’s value how impotis your equity. Over time, as you make mortgage payments and your home’s value (hopefully) increases, your equity can grow.
You can use this equity as collateral for a loan, and borrow money to make home improvements or upgrades, send a child to college, consolidate high-interest credit card debts, pay for emergency medical expenses, or just about anything else.
Even if you have bad credit, you may be able to qualify for a home equity loan or line of credit, although you won’t get as good an interest rate as someone with excellent credit.
In this guide, we’ll cover:
- Home Equity Loans vs. Home Equity Lines of Credit
- Shopping for a HEL or HELOC
- What fees should I know about?
- What it takes to qualify
- How important is your credit score?
- How much can you borrow with a home equity loan?
- Risks when taking out a home equity loan
- Alternatives to a home equity loan
Home Equity Loans vs. Home Equity Lines of Credit
Home equity loans (HEL): You borrow a lump-sum amount based on the equity in your home. Then you have a fixed amount of time to repay the debt, typically five to 15 years.
Home equity line of credit (HELOC): Your lender sets a credit limit based on the equity in your home, and you can borrow against that limit at any point while the line of credit it still open, typically five to 10 years. Then you have between 10 to 20 years to repay the loan.
These products are often called second mortgages for a reason. For both types of loans, your home is the collateral. So if you miss payments, you could potentially lose your home.
The primary difference between the two home equity loan options is that with a HEL, you’ll receive the money upfront and then pay down the loan over time. In contrast, HELOCs are revolving lines of credit, similar to credit cards. But unlike credit cards, you get several years — called a “draw period— during which you can withdraw funds from your HELOC before you have to start paying the loan back.
Pros and cons of a Home Equity Loan
- As with a mortgage, your interest payments may be tax deductible for qualified expenses.
- HELs also have a fixed interest rate, and you’ll know exactly how much your monthly payments will be and when you’ll pay off the loan. Generally, the terms are around five to 15 years. A HEL could be best for a one-time expense because you’ll receive a single disbursement and then pay off the debt over time.
- But when you take out a home equity loan, you’re also putting your home at risk if you find yourself in a financial emergency and can’t afford to make your monthly payments.
- If you sell your home, you’ll need to pay any remaining debt from a HEL.
Pros and cons of a Home Equity Line of Credit (HELOC)
- HELOCs have a draw period, often around five to 10 years, during which you can borrow against the credit line if you have available credit or if you repay part of the principal.
- After the end of the draw period, you’ll enter the repayment period, which is generally 10 to 20 years. At this time, you’ll start to make larger interest and principal payments.
- Monthly interest payments due immediately. With a HELOC, you’ll get checks or a card linked to the credit line and can use them to draw money up to your credit limit. Once you draw against the credit line, you’ll have to start making monthly interest payments. Because HELOCs have variable interest rates, your monthly payment amount could change.
- You may have to withdraw a minimum amount when you first open the line of credit, and there could be minimums on future draws. Some lenders may also let you lock in an interest rate on draws if you’re in the draw period.
- If you sell your home, you’ll need to pay any remaining debt from a HELOC.
Shopping for a HEL or HELOC When You Have Bad Credit
Because you’re securing the loan with a large asset (your home), people with poor or bad credit can qualify for a home equity loan or line of credit. Whether you’re looking for a HEL or HELOC, lenders may have a set of criteriayou’ll need to meet to qualify. These can vary from one lender to another, which is one of the reasons it’s important to shop around and compare your offers.
Don’t let your poor credit score deter you from aggressively comparing offers for HEL or HELOCs. There’s no better way to ensure you are getting the best possible rate. Check out our home equity loan comparison tool, which allows you to compare rates easily online.
Once you’ve determined which option to move forward with, you’ll need to gather and share your documents. The application process can be similar to applying for a mortgage, and you may need:
- Personal information, such as your name and Social Security number, and a photo ID.
- Personal information for a co-applicant or spouse.
- Proof of employment or other income.
- Recent tax returns.
- Home insurance policies.
- An estimated property value and property tax amounts.
- Bank statements.
- Information about other properties or assets you own.
After you submit your application, it will be sent through processing and underwriting. You may then need to share additional information, such as a credit report or verify your income.
What fees should I know about?
There are also potential fees for HELs and HELOCs.
HELOCs generally don’t have closing costs, but you may have to pay an annual fee, inactivity fee, and early-termination fee if you decide to close the credit line early. HELs may have closing costs, fees for obtaining your credit reports or hiring an appraiser, and a prepayment penalty.
Your original mortgage lender may also be a good option since you have a financial relationship with them. But don’t get tied down. Comparing lenders and negotiating could save you money on fees and interest. You may also be able to get a lower interest rate and some of the fees waived, including a HELOC’s annual fee, by maintaining a checking account with the lender.
What it Takes to Qualify for a Home Equity Loan
However, here are some common requirements for home equity loans:
- Equity in the home. You’ll need equity in the home if you want to borrow money using the home as collateral. The more equity you have, the higher your loan-to-value (LTV) ratio will be, which is how lenders determine how much you owe versus the actual value of your home. You may only be able to borrow if your combined LTV is 80 to 90 percent, which means lenders won’t let you carry debt that is more than 80 to 90 percent of your home’s value
- Good credit. Some lenders have minimum credit scores, such as a 620 FICO score, for their home equity loans. However, qualifying with the minimum credit score may not get you as good a rate as someone who has excellent credit. If you don’t meet one lender’s minimum credit requirement, you can still shop around and look for options from other lenders.
- A clean credit history. Even if your credit score is decent you may have prior financial mishaps that can hurt your chances of approval. If you have a past bankruptcy or foreclosure, you may have trouble qualifying within the following seven years. Lenders may have their own time frames or rules, and the time frame may be shorter if you’ve rebuilt your credit and there were extenuating circumstances that led to the bankruptcy or foreclosure.
- A low debt-to-income (DTI) ratio. To find your DTI, add up all your monthly credit obligations, including mortgage, auto, and credit card payments and divide the sum by your monthly income. (Or use this handy calculator.) Home equity lenders may want you to have a DTI, including the new loan, below 43 percent.
Although these are common requirements among home equity loan providers, specifics can vary from one lender to another. There may also be some non-finance-related requirements, such as living in the home you’re using as collateral.
How important is your credit score?
Credit score requirements can sometimes be less rigid with a HEL or HELOC than when you apply for an unsecured loan, such as a personal loan. That’s because you’re offering something of value, your home, as collateral.
But your credit score can still play a crucial role in your ability to get a home equity loan and the terms you’re offered. A low score could result in a higher interest rate and fewer loan options.
FICO maintains a chart with the average annual percentage rate (APR) and monthly payments on HELOCs, 10-year home equity loans, and 15-year home equity loans, depending on applicants’ credit scores.
As of the time of writing, for a $50,000 15-year HEL, the national average APR is 10.33%, and the monthly payment is $547 for someone with a FICO score of 620-639. Those with the highest scores, 740-850, may qualify for a loan with a 6.005% APR and $422 monthly payments. Over the lifetime of the loan, the person with the low score will pay over $22,500 more in interest.
If you want to improve your credit score to better your odds of qualifying for a home equity loan, there are some simple steps you can take. Start by knowing where you stand. You can check your credit score for free on LendingTree.com, and follow some best practices to improve your score over time. Also, review your credit reports for inaccurate information. If there are mistakes on your reports, you can send a dispute to the credit bureau and ask it to remove the inaccurate information. You might see a quick boost in your score.
Another option is to apply for a home equity loan with a co-signer who has better credit. However, your co-signer may need to live with you, or be your spouse or relative, to qualify as a co-applicant.
How much can you borrow with a home equity loan?
You may have a specific use for the money in mind when applying for a home equity loan. But how much you can actually borrow depends on several factors.
Your LTV plays an important role in determining your borrowing limit. For example, if your home is worth $100,000 and you have a $70,000 mortgage, your equity is the remaining $30,000. You therefore may be able to get a loan for $20,000, bringing your total loan balance to 90 percent of the home’s value.
Todd Huettner, president of Huettner Capital, a real-estate financing firm in Denver, Colo., says that lenders may have a maximum LTV based on your credit score. In the example above, if you have bad credit, you may only be able to borrow $10,000 for an 80 percent LTV.
The same is true for the DTI, says Huettner, and lenders may allow applicants with excellent credit to have a higher DTI than those with poor credit.
Some lenders may also have minimum loan amounts. Even if you qualify based on all the other criteria, you might not be able to get a home equity loan for only $5,000 and instead have to borrow $10,000 or $15,000. You’ll then have to pay interest on the debt, and there could be a prepayment penalty if you try to immediately pay off the unused portion.
There may also be maximum dollar-value amounts regardless of your LTV, which could be an issue when you need to borrow very large sums.
Risks when taking out a home equity loan
While a home equity loan may seem like a good way to quickly access a large amount of cash, it’s not always the best option. Huettner says, “If you’re looking for a home equity loan and don’t have good credit, ask yourself why you need the money and why you have bad credit.”
By putting your home up as collateral, you risk losing your home if you can’t afford a payment. And if you already have a poor credit score due to overspending, your finances may be tight.
Some uses for the money may also be better than others. For example, taking out a home equity loan to remodel, repair or expand your home could add to the home’s value.
Using your home’s equity to consolidate unsecured debts, such as credit cards, can save you money on interest and improve your credit score because you’ll lower your utilization rate. However, you’re also transferring unsecured debts to a secured debt. You’ll be taking on more risk, and “if you can’t control your spending, you’re just kicking the can down the road,” says Huettner.
Alternatives to a home equity loan
If you decide against a home equity loan or don’t qualify for a desirable amount or terms, you could still turn to other sources for funding.
Cash-out refinance: With a cash-out refinance, you’ll take out a new mortgage to replace your current mortgage, plus you’ll borrow extra that you get to keep as cash. It may be a simpler process, and you’ll only have one mortgage payment each month.
Huettner says that the fees and costs associated with a HELOC could be higher than a cash-out refinance for those with low credit scores. However, as with the home equity loan, it may be difficult to secure a good rate on a cash-out refi without a good credit score.
Personal loan: A personal loan lets you borrow money without putting up any collateral. Some lenders may have a lower required credit score, such as 580 or 600, for a personal loan than what you might need for a home equity loan.
The interest rate could also be over 35 percent — even higher than a credit card. But if you don’t have a credit card and don’t want to risk losing your home, a personal loan may be worth considering.
Other options may include a different type of secured loan, such as a loan against a car or boat. Depending on the circumstances, it also may make sense to sell or downsize some assets to raise money.