One of the biggest benefits of owning a home is the ability to build equity. With a home equity loan or line of credit, you can take advantage of the existing equity in your home to finance home improvements, consolidate debt or pay for other big expenses.
Getting home equity financing is a fairly simple process, but one worth your due diligence. Lenders across the board have standard criteria that homeowners must follow to qualify for either loan, but each one has their own specific requirements. Before applying, compare different lenders and take a look at the application requirements -- which most banks provide online.
Home equity loans and HELOCs can be a great option for homeowners in need of access to cash, but there’s always a risk when you borrow against your home. If you default on your payments, you run the risk of losing your home.
Below, we’ll cover the general criteria for home equity financing to help you get started.
How do home equity loans and HELOCs work?
Home equity loans and HELOCs are secured loans, meaning you use the difference between what your home is worth and what you owe on your mortgage as collateral. Because they are secured by your home, the interest rates for home equity loans and HELOCs tend to be lower than other loans, such as a personal loan or credit card.
A home equity loan provides you with a one-time lump sum of cash. Over a period of five years or longer, you’ll pay back the loan at a fixed rate. Your monthly payment will remain the same even if rates change.
A HELOC is a flexible lending option, meaning you can withdraw funds as needed. While there’s a limit to how much you can take out at once, you’ll only pay interest on what you’ve borrowed during the draw period. Unlike home equity loans, though, interest rates for HELOCs are often variable, meaning your monthly payments could be unpredictable.
“Both options allow homeowners to maintain their existing primary mortgage which, for most homeowners, were obtained when rates were much lower,” Rob Cook says. Cook is vice president of marketing, digital and analytics for Discover Home Loans.
Before borrowing with a home equity product, remember: The loan is guaranteed by a collateral -- your home. If you are unable to cover your monthly payments, your home could be repossessed.
How much can you borrow with a home equity loan or HELOC?
Lenders typically allow a homeowner to borrow up to 80% to 85% of their home’s value. This doesn’t include the remainder of their mortgage balance.
You can determine how much money you’ll be able to obtain from a home equity loan by starting with the current value of the home. If, for example, your home is worth $300,000 and a bank lender allows you to borrow up to 85% of the value of your home, you simply multiply the two values to get the maximum amount you can borrow, which is $255,000.
$300,000 x 0.85 = $255,000
But if you have a balance on your mortgage of $200,000, you need to subtract it from the $255,000 maximum the bank will let you borrow. That means you can borrow $55,000 for a HELOC.
$255,000 – $200,000 = $55,000
Requirements to borrow home equity
The requirements to qualify for either a home equity loan or HELOC are similar. Although each lender has its own qualifications, the following checklist provides general criteria to help you get started.
Have at least 15% equity in your home
Home equity is the amount of the home that you own. The amount of equity includes the amount of your down payment, plus all the mortgage payments you’ve made over the years.
Subtract the loans you owe such as your mortgage from the appraised value, which comes from your county appraisal district, to determine the amount of your equity.
Your loan-to-value ratio shouldn’t exceed 80%
The loan-to-value ratio, or LTV, is used by lenders to determine whether you qualify for a home equity loan. It’s derived from dividing the current loan balance by the home’s appraised value and expressed as a percentage value. In the above example, if your loan balance is $200,000 and your home is appraised at $300,000, divide the balance by the appraisal and you get 0.67, or 67%. Therefore, your LTV is 67%, which means you have 33% of equity in your home.
The LTV ratio shouldn’t exceed 80% of the home’s value. Mortgage lenders such as Fannie Mae and Freddie Mac can approve home loans only up to a maximum ratio of 80%. Having an LTV ratio of less than 80% is considered good. If you have an LTV ratio higher than 80%, you may be declined for a loan. Worse yet, at that level, you may need to buy mortgage insurance, which protects the lender in the event that you default on your loan and the lender needs to foreclose on your home.
A combined loan-to-value ratio, or CLTV ratio, is the ratio of all secured loans on a home to the value of the home. It includes all the loans connected to your home, such as your current first mortgage plus either a home equity loan or HELOC that you’re seeking. The CLTV is used by lenders to determine the homebuyer’s risk of default when more than one loan is used. You can typically borrow up to a CLTV ratio of 85%. That means the total of your mortgage and your desired loan can’t exceed 85% of your home’s value.
A higher down payment amount and paying down your mortgage are two ways to lower your LTV. Having a lower LTV means less risk for mortgage lenders.
Homeowners can build home equity through various options. A larger down payment of more than 20% will increase the amount of equity. Higher appraisals from a county assessor that increases the value of the home will also yield more equity. Making extra payments towards your mortgage will also increase your equity because you owe less money.
Have a credit score in the mid-600s or higher
A good credit score will make you eligible for a loan at a lower interest rate, which will save you a substantial amount of money over the life of the loan. Lenders also use your credit score to determine the likelihood that you’ll repay the loan on time, so a better score will improve your chances of getting approved for a loan with better terms. A credit score of 680 will qualify you for a loan with amenable terms provided you also meet equity requirements. A score of at least 700 will make you eligible to receive a loan at lower interest rates.
Your debt level shouldn’t exceed 43%
Your debt level is determined by your debt-to-income ratio, which is simply your total monthly debt payments divided by your total gross monthly income. The DTI ratio helps lenders determine if you’re capable of paying back your loan on time and of making consistent monthly payments.
In determining DTI, lenders tally the total monthly payment for the house -- mortgage principal, interest, taxes, homeowners insurance, direct liens and homeowner association dues -- and any other outstanding debt. That total debt is then divided by your monthly gross income to get your DTI ratio.
Some lenders prefer that your monthly debts don’t exceed 36% of your gross monthly income, but many others are willing to go as high as 43%. If your DTI ratio is higher than 43%, consider paying down your debts first to the point where your DTI ratio is less than 43%.
The bottom line
A home equity loan and a HELOC are two ways you can tap into the equity of your home. To qualify for either loan with reasonable terms, you should have at least 15% to 20% of equity in your home, a LTV ratio of 80% or lower, a credit score of at least 620 (the higher, the better) and a DTI ratio no higher than 43%.
Couple these criteria with a reliable payment history and source of income to ensure that you can be eligible for a home equity loan or HELOC. Specific qualifications may vary between lenders so take the time to shop around and compare.
FAQs
Some lenders will provide a home equity loan or HELOC if you don’t have a job or are retired, but instead have regular income from a retirement account such as a pension. The income can also come from a spouse or partner’s employer, government assistance or alimony.
Lenders are typically seeking at least 15% in equity from the home since many of them will allow you to borrow a maximum of 85% for the value of the home for either a HELOC or home equity loan.
Lenders prefer good credit scores that are 680 or higher if you have enough equity in the home. The majority of lenders seek a credit score of at least 700. A higher credit score means less risk for a bank or mortgage company, which means interest rates are often lower.
You can improve your credit score before you apply for a home equity loan by making payments on time, paying down the amount that’s owed on credit cards and avoiding taking out any new loans from buying a new or used car or purchases such as major high-end appliances like refrigerators and ranges.
