Do I Need Good Credit for a Home Equity Loan?

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Credit score requirements for a home equity loan are similar to those of a conventional mortgage loan. So while a credit score in the mid-600s might be enough to get approved with some lenders, it's no guarantee.

Even if you have a credit score above 700, however, it might not be enough to get approved. That's because lenders look at a variety of factors, including your debt-to-income ratio, equity in the home and credit report when considering you for a home equity loan.

Read on to learn what else you need in addition to a great credit score to get approved for a home equity loan.

What Is a Home Equity Loan?

A home equity loan is just what its name suggests: a loan secured by the equity in your home. Your equity is the difference between your mortgage balance and the market value of the home.

For example, if you have a mortgage with $150,000 left to pay and your home was recently appraised at $200,000, your equity is $50,000. Depending on the lender, you could borrow up to 80% to 90% of that amount using your equity as collateral.

Even if you think you know the market value of your home, however, the lender may require that a certified appraiser perform a separate valuation. At that point, you'll know how much you can borrow.

Just because you have equity, though, doesn't mean you can secure a loan. Your credit score and other factors will also come into play.

Why Your Credit Score Matters

Your credit score is a reflection of how you handle credit and debt. An exceptional credit score is a sign to prospective lenders that they can trust you to repay your loan on time. A score in the good range might be enough to get approved for a home equity loan, as long as you're working with the right lender and your overall financial profile is satisfactory. However, the lender may still view you as a risk and charge a higher interest rate.

But if your credit score is in the poor to fair ranges, it may signify that you're new to credit or have made credit missteps in the past.

Before you apply for a home equity loan, check your credit score to see where you stand. If it needs work, get a copy of your credit report to see where you can improve.

If there are any errors, report them to Experian and the other credit bureaus (TransUnion and Equifax) as soon as possible. If not, focus on areas of weakness.

For example, if you have outstanding delinquencies, get current on your payments quickly. If your credit card balances are high, create a strategy to pay them down. With each issue you find, work on a solution sooner than later.

How Your Debt-to-Income Ratio Plays a Role

Your debt-to-income ratio (DTI) is a measure of how much of your monthly income goes to service debt. To calculate your DTI, divide your monthly debt payments by your gross income.

For example, let's say you have a gross monthly income of $5,000 and the following monthly payments:

  • $1,000 mortgage payment
  • $100 credit card payment
  • $250 car loan payment
  • $300 student loan payment

That's a total of $1,650 in debt, giving you a DTI of 33%. To give you an idea of how that stacks up, many mortgage lenders prefer a ratio below 36% when originating a first mortgage loan. Other lenders might be fine with a DTI of 50% or below.

That said, DTI requirements for a home equity loan can vary by lender. If you find that your DTI may be considered high, it's better to be safe than sorry. You can avoid a potential denial by paying down existing debt before applying for a home equity loan. You'll also be better off financially with less debt eating up your income.

What Your Credit History Says About You

While your credit score is a key measure for determining your creditworthiness, lenders also like to check your credit report to see if there are any red flags.

For example, it's possible to have a decent credit score but have bankruptcy on your credit report from a few years ago. In this situation, the bankruptcy could hurt your chances of getting approved.

More important, lenders will want to see how you've handled past mortgage loans. If you have a short sale or foreclosure on your report, it could be a deal breaker.

Again, check your credit report to make sure there aren't any errors or fraudulent accounts. If you've filed bankruptcy in the last few years or have a short sale or foreclosure, you may still have a chance of getting a home equity loan. It just means you'll need to do more legwork to find lenders that are willing to work with you.

Is a Home Equity Loan Right for You?

Home equity loans can be a good borrowing option in the right circumstance, but there are some things to consider. Here's a quick summary of the pros and cons.

Pros of a Home Equity Loan

Low interest rates: While a lower credit score could give you a higher interest rate, you'll likely still get a lower rate than you would with a personal loan. That's because the collateral—your home's equity—lowers the risk to the lender.

Interest may be tax-deductible: If you use your loan to buy, build or substantially improve the home you use to secure the loan, you may be able to deduct the interest you pay. The deduction is available for qualified mortgage loans up to $750,000.

No restrictions for how you use the money: Home equity loans function similarly to personal loans in that they don't require that you use the loan for a specific purpose. This means you can use a home equity loan to consolidate other debt, pay for home improvements or cover the cost of tuition for one of your children.

Find the best personal loans with Experian.

Cons of a Home Equity Loan

You could lose your house: Because your loan is secured by your home's equity, the lender has a right to that equity if you default on the loan. To get its collateral, the bank could foreclose on you and take the house to satisfy the debt.

High costs: Just like your mortgage loan, home equity loans typically come with closing costs and fees. Depending on the lender, these costs could neutralize the savings you'd get with a lower interest rate.

You could end up underwater: If you tap a large portion of your home's equity, it could leave you owing more than the house is worth if property values drop in your area.

The Bottom Line

Before you borrow with a home equity loan, it's important to know what you're getting yourself into. It's also essential to understand what your chances are of getting approved. If your credit score, DTI or credit report need some work, put off borrowing until they're in better shape.