If you have bad credit, you may think that a home equity loan is out of reach. Unlike first mortgages, though, there’s a bit more flexibility in home equity programs. Most lenders have their own programs that they don’t have to follow investors’ guidelines on, making it easier for you to find a loan that suits you.
Keep reading to learn more about how to get a home equity loan with bad credit.
You Need Compensating Factors
If you have bad credit, you need to give lenders another reason to want to lend to you. Anyone can have a low credit score – life happens. But what you have done to bring things back around and the other ways you shape your finances can help lenders see you as a responsible borrower rather than a risky one.
Your debt ratio is the largest compensating factor. You want it as low as possible. Conforming debt ratios are 28% on the front-end (housing ratio) and 36% on the back-end (total debt ratio). Using those numbers as your target, you can figure out where you stand.
Lenders want borrowers that don’t have an overwhelming amount of debt on them already. The fewer debts that you have, the more likely you are to make your payments on time. That’s what lenders want. You figure out your debt ratio with the following calculation:
Total monthly debts/Gross monthly income = Total debt ratio
Mortgage payment (first and second)/Gross monthly income = Housing ratio
The lower you can make these numbers by increasing your income or decreasing your debts, the higher your chances of getting a home equity loan even with bad credit become.
Other compensating factors that may help include:
- Stable employment – If you’ve been at the same job for 10 years and your income increased every year in that time, this shows lenders that you are consistent and responsible.
- Assets on hand – If you have a savings account or liquid investments with a few months’ worth of mortgage payments in it, lenders will feel that you aren’t a high risk. You have a back-up plan to make your payments should your income stop.
Your Loan-to-Value Ratio
Next, lenders care about your loan-to-value ratio. First, figure out your LTV with your first mortgage. You need your outstanding principal balance on your loan first:
Outstanding principal balance/Home value = Loan-to-value ratio
If this number is less than 80%, you are in good shape. Next, figure out your total LTV with your potential home equity loan payment in it by using the same calculation, just include the home equity payment too.
Again, keep the number around 80% – lenders like it when you keep at least 20% equity in your home. This way if you do default on your mortgage, lenders have a little wiggle room as they try to sell the home for less than its value. The idea is that the lender loses as little money as possible, if that has to be the case.
You May Still Need to Work on Your Credit
Don’t forget that your credit score does play a role. Lenders look at the big picture – your credit score, DTI, and LTV. If your DTI and LTV are good, then you may get away with having a lower credit score (say below 650).
If your DTI and LTV aren’t so good, though, you may need that higher credit score to convince a lender to give you a home equity loan. A few ways you can fix your credit include:
- Pay your debts down. The lower your outstanding balances, the higher your credit score becomes. Too much outstanding debt poses a high risk of default, which lowers your credit score.
- Pay your bills on time. If you have late payments, bring everything current. It will take a few months for your credit score to adjust, but it will happen with timely payments.
- Don’t close your old accounts. You need your credit age to be as old as possible. Keeping old, yet unused accounts open helps make that happen.
- Don’t open new accounts. Try avoiding applying for any new credit when you know you need to increase your credit score. Save it for your home equity loan application.
Getting a home equity loan with a low credit score is possible – you just have to find the right lender and create the right situation. With all of the pieces of the puzzle fitting together, lenders will give you a home equity loan, mostly because they have your home as equity should you default.