Owning your home free and clear makes it easier to get a home equity loan because it means that you have 100 percent equity and a lender can assume first lien position on your house. However, if you have bad credit you may find it hard to qualify for a loan regardless of your equity.
Before extending credit to you, a lender must conduct a risk assessment that involves reviewing your credit score to determine how likely you are to repay the loan. When you pay credit cards or loans late, it has a negative impact on your credit score. Judgments related to unpaid debts and events like foreclosure and bankruptcy can severely damage your credit score. By comparison, lenders are less likely to approve a loan for someone with bad credit than someone with good credit because history suggests that the person with bad credit may default on the loan.
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Home equity loans expose lenders to a lower level of risk than unsecured debts because if you default on the loan, the lender can seize your home and sell it to raise money to payoff the loan. Many people take out home equity loans as second liens behind a mortgage. In these situations, the home equity lender may end up taking a loss if the borrower defaults and the home sale does not raise enough money to cover both loans. However, if you own your home free and clear, your lender assumes less risk and therefore the lender may consider writing a loan for you despite your bad credit.
People with good credit pay low interest rates, but even on low interest home equity loans, banks make huge profits over long periods. Some banks write home equity loans for people with bad credit and charge very high interest rates. If you pay two or three times as much interest as someone with good credit, then the bank can make money on your loan twice or three times as fast. If you never default on the loan, the bank makes a big profit -- even if you do default on the loan -- because the bank has already recouped much of its upfront costs.
If you can find a lender willing to lend despite your bad credit, there are still several other factors to consider. You cannot get a loan unless you have sufficient income to take on the new payment. You cannot borrow money against a home in a state of disrepair and some lenders do not write loans against property such as mobile homes or condominiums. Therefore, your bad credit score can make it hard to borrow, but so can many other factors.