Breaking into the home equity nest egg is becoming a very real possibility for more Americans as home prices rise. But raiding the house bank is not as easy as it was before the recession, and not everyone meets the requirements to borrow from home equity.
Consumers must have a trifecta of enough equity, a high credit score and a healthy relationship between their debt and income to take money out of their house via a cash-out refinance, home equity loan or home equity line of credit, also called a HELOC.
Home equity loan
A second mortgage for a fixed amount, at a fixed interest rate, to be repaid over a set period.
Home equity line of credit (HELOC)
A second mortgage with a revolving balance, like a credit card, with an interest rate that varies with the prime rate. Pronounced HE-lock.
A mortgage refinance for more than the amount owed. The borrower takes the difference in cash. Also called a cash-out refi.
"The standards were already fairly tight, but now with a lower volume of refis being done, you have more people looking at every file," says Paul Anastos, president of Mortgage Master Inc. "There's more scrutiny from banks and the agencies."
You can extract equity in multiple ways
Some banks remain hesitant to offer equity lines of credit to homeowners. Lenders also must follow stricter mortgage rules that went into effect in 2014 about a consumer's ability to repay the debt.
Using 1 of his cash-out refinances as an example, Stearns says the borrower took out $50,000 in home equity. After the loan closed, the borrower still had a 40% stake in the property. That translates to a healthy 60% loan-to-value ratio, or LTV -- a figure that reflects how much debt remains on the property. The lower the ratio, the better.
You need lots of equity to borrow from it
Home prices rose year over year for the 22nd straight month in March 2014, according to the S&P/Case-Shiller index of home prices. That run helped 4 million mortgaged properties regain equity in 2013 and boosted Americans' overall stakes in their homes to over 50% for the first time in 6 years.
Still, lenders require a hefty amount of equity before homeowners can borrow against their home. In general, a homeowner cashing out into a fixed-rate mortgage must have at least 15% equity left over, or a loan-to-value ratio of 85%, according to rules spelled out by Fannie Mae and Freddie Mac, which guarantee the majority of U.S. home loans.
If the homeowner chooses an adjustable-rate mortgage when cashing out, then the maximum LTV is 75%. The LTV requirements for cash-out refis differ even more if the home is a second house, an investment property, a mobile home or a multiple-unit dwelling.
For HELOCs, lenders generally want the LTV to be 80% or less, says Pava Leyrer, director of training and implementation for Northern Mortgage Services in Grand Rapids, Michigan.
"The reason why most want to keep that 20% stake is because it will cover the cost to take back the property in foreclosure and turn around and sell it," Leyrer says.
Lenders scrutinize total debt payments
LTV is not the only key percentage to tap home equity. The ratio between a consumer's total debt and income is also part of the qualification equation. And again, the lower the percentage, the better. The magic number, according to Fannie Mae and Freddie Mac, is 45%.
Lenders will add up the total monthly payment for the house, which includes principal, interest, taxes, homeowners insurance, direct liens and home association dues, along with any other outstanding debt that is a legal liability. That can include child support, installment loans, credit card bills, IRS payments and even student loans that are not yet being repaid, Leyrer says.
That total debt is divided by a borrower's gross monthly income, which comprises base salary, commissions, bonuses and any other income such as rental income or on-time, up-to-date spousal support.
"Lenders want to see if after making your monthly debt payments, is there any money left over at the end of the month," says Dave Norris, president and chief operating officer of LoanDepot.com.
And then there's the credit score
Even if a borrower's income shows ability to repay the loan, that doesn't mean the borrower will, Norris says. That's where a borrower's credit score comes in. For HELOCs, Leyrer says most borrowers with a credit score between 660 and 680 will probably qualify, but a score of 700 is "more of a shoo-in."
You can keep an eye on your credit score for free at myBankrate.
For a cash-out refi on a home the borrower lives in, generally, the lowest credit score is 640, according to Fannie Mae's standards. But such a loan comes with caveats. The borrower can't have an LTV ratio higher than 75%, must have 6 months of reserves in the bank and a debt-to-income ratio of 36% or lower. Those stipulations disappear as the credit score, LTV or debt to income improves.
Requirements for cash-out refinance on primary home
|36% or less||More than 75%||680||N/A|
|36% or less||75% or less||660||N/A|
|36% or less||More than 75%||660||6|
|36% or less||75% or less||640||6|
|45% or less||More than 75%||700||N/A|
|45% or less||75% or less||680||N/A|
|45% or less||More than 75%||680||2|
|45% or less||75% or less||660||2|
Source: Fannie Mae
"They all play off one another," says Norris. "You would also get a better interest rate as each factor improves."