Home equity loans are a way for property owners to turn the unencumbered value of their homes into cash. And if you have bad credit, a home equity loan is more likely to be approved by a lender, and at a lower interest rate, than either a traditional loan or a revolving line of credit. 

The reason is that your home serves as the security or collateral for the loan, making you less of a financial risk in a lender's eyes. Lenders will typically make loans for up to 80% of the equity you have in your home, and the more equity you have, the more attractive a candidate you will be, especially if you own 20% or more of the home free and clear. This can be particularly helpful when you have a poor credit score.

Key Takeaways

  • Home equity loans let property owners borrow against the debt-free value of their homes.
  • If you have bad credit you may still be able to get a home equity loan.
  • A major downside is that you'll be putting your home at risk if you can't repay.

Downsides of Home Equity Loans

While a home equity loan can be useful if you have bad credit, there are some downsides. You can expect less favorable terms on your home equity financing, for example, than if your credit were better. You may be limited to a lower loan amount and have to put up more collateral (greater equity). You may also have to pay a higher interest rate.

A home equity loan also adds to your mortgage debt on the property, which could put you in a vulnerable position if you lose your job or face unexpected bills and find it difficult to make all of your payments on time. What's more, you may get hit with hefty late-payment fees that your lender will report to the credit bureaus, making your credit even worse.

The biggest downside is that the lender could foreclose on your property if you're unable to pay the debt, leaving you without a place to live.

Home Equity Loans vs. HELOCs

There are two main types of home equity financing. With a home equity loan, you borrow a lump sum of money and repay it in regular installments, typically at a fixed interest rate, over 25 to 30 years.

The second type is a home equity line of credit (HELOC), where the lender sets aside an amount of money that you can borrow from as needed. Most HELOCs charge adjustable interest rates, offer interest-only payments, and have a 10-year “draw” period, during which you can access the funds. After the draw period ends, you have to repay the outstanding balance over a certain period, typically 15 years.

Steps to Take Before You Apply

Here is what you need to know and do before applying for any type of home equity financing.

1. Read your credit report

Get a copy of your credit report, so you know exactly what you’re up against. You’re entitled to a free one every year from each of the three major national credit bureaus (Equifax, Experian, and TransUnion) through the official website AnnualCreditReport.com. Check the report thoroughly to make sure there are no errors that are hurting your score (it's smart to do this every year anyway). 

2. Prepare your financials

Gather your financial information, such as proof of income and investments, so it’s ready to present to lending institutions. They’ll want to see in black and white that you’re financially stable enough to support your loan, especially if you’ve got bad credit. If possible, pay off any outstanding debt that could adversely impact your application.

If borrowing can wait, you might want to use the time to improve your credit score.

3. Consider how much cash you need

Ask yourself: What is the purpose of this loan? And how much money do I need for that purpose? It can be tempting to shoot for the stars and maximize your loan amount, perhaps to provide a financial cushion just in case. But that's only if you're sure you can resist the temptation to spend it all. If your spending habits are under control, it may make sense to “borrow up,” and by using a HELOC, you’re only paying interest on the money you actually take out. However, in the case of a home equity loan, you’ll be paying full interest (and principal) on the entire lump sum, so it makes sense to borrow no more than you need.

4. Compare interest rates

It’s logical to head straight to your existing lender for home equity financing, and, given that you’re already a client, that lender may offer a more appealing rate. However, this isn’t guaranteed, particularly if you have bad credit, so it's wise to shop around. By obtaining multiple quotes, you’ll be in a better position to negotiate the best possible rate. Present your first offer to another lending institution and see if it will beat it. A mortgage broker may also be of help.

5. Don't forget the other costs

When you're comparing loan offers, don't focus solely on the interest rate. Be sure to ask about any other associated fees, such as loan processing and closing costs. That way you can compare loans on a fair basis and won't be in for any budget-busting surprises later on.

6. Recruit a co-signer

To put yourself in a better position to borrow, it may be a good idea to bring in a co-signer, someone who uses their credit history and income to serve as a guarantor for the loan. Be sure to choose a co-signer with impressive credit, good job stability, and significant income to maximize your chance of approval. That person, of course, should be aware of the risks of co-signing a loan if you are unable to pay it back.

7. Look at subprime loans, maybe

As a last resort, you can turn to lenders offering subprime loans, which are easier to qualify for and targeted to poor-credit borrowers who don’t meet traditional lending requirements. Subprime lenders typically offer lower loan limits and significantly higher rates of interest. However, you should avoid these loans if at all possible, especially if you are already in credit trouble.

The Bottom Line

If you find that a poor credit history is working against you, ask your lender what it would need to see from you (and your credit report) to improve your prospects. It's never too late to turn your credit score around. If possible, consider putting your borrowing plans on hold while you take steps to improve your rating.

Mortgage lenders typically look at such factors as your payment history, your existing debt load, and how long you've had your credit accounts. Do you frequently miss payments, run up big balances, or apply for new accounts? Just changing one of these behaviors can positively affect your credit score—and make future borrowing easier.