Tapping home equity can be a smart way to borrow cash to pay for home improvement projects or pay off high-interest debt. If you have substantial equity in your home because you’ve either paid down your mortgage or the home’s value has spiked, you might be able to snag a sizable loan.
What it takes to borrow from home equity
There are three ways to tap into your home’s equity: a home equity loan, home equity line of credit or cash-out refinance.
Before you apply for a loan, you should:
- Determine how much equity you have.
- Check your credit score.
- Look at your debt-to-income ratio.
1. Determine how much equity you have
Equity is the difference between how much you owe and how much your home is worth. Lenders use this number to calculate your loan-to-value ratio, or LTV, a factor used to determine whether you qualify for a loan. To get your LTV, divide your current loan balance by the current appraised value.
Let’s say your loan balance is $150,000 and your home is appraised at $450,000. Divide the balance by the appraisal and get 0.33, or 33 percent. This is your LTV ratio.
Determining your home’s value entails an appraisal. Your lender might request a certified appraiser to inspect your home.
For HELOCs, you need to figure out your combined loan-to-value ratio, or CLTV. This is determined by adding how much money you want to borrow, either as a lump sum or a line of credit, and how much you owe.
For example, if you want $30,000 and you owe $150,000, then you would add those numbers together and divide them by the appraised value. If the home is valued at $450,000, then the equation would look like this: ($150,000 + $30,000) / $450,000 = 0.4 or 40 percent. Your CLTV is 40 percent.
Most lenders will require a CLTV of 85 percent or less for a HELOC approval.
2. Check your credit score
Having equity is not enough to secure a loan from most banks. A favorable credit score also is essential.
Alex Shekhtman, mortgage broker at LBC Mortgage in Los Angeles, says that banks are still weary from the 2008 housing crash.
“If you don’t have good credit or you owe a lot already, it’s going to be more challenging to get a loan from one of the big banks,” Shekhtman says. “Banks lost a lot of money during the recession, and now they’re much more careful about who they lend to.”
A credit score above 700 most likely will qualify you for a loan, as long as you meet the equity requirements. Homeowners with credit scores of 621 to 699 might be approved, but most likely at higher interest rates. Those with scores below 620 probably won’t qualify.
You can get your credit report and score for free at myBankrate. Some credit card companies and banks will offer cardholders their score for free, so be sure to check with your financial institution before you pay for your score.
Consumers are entitled to a free credit report every year from each of the three main credit-reporting agencies: Experian, TransUnion and Equifax.
Review your credit reports to make sure there are no errors. If you find a mistake, such as a late payment, report the problem to the credit bureau that’s showing the information. Your score likely will improve once the error is removed.
3. Look at your debt-to-income ratio
Your debt-to-income ratio, or DTI, is also a factor lenders consider with home equity loan applicants. The lower the percentage, the better. The qualifying DTI ratio varies from lender to lender, but most require that your monthly debts eat up less than 50 percent of your gross monthly income.
Lenders will add up the total monthly payment for the house, which includes mortgage principal, interest, taxes, homeowners insurance, direct liens and homeowners association dues, along with any other outstanding debt that is a legal liability.
The debt total is divided by the borrower’s gross monthly income — which includes base salary, commissions and bonuses, as well as other income sources such as rental income and spousal support — to come up with the DTI ratio.
You can improve your DTI by earning more money, lowering your debt or both.
Before you apply for an equity loan, be sure to calculate your DTI. If you’re above the optimum ratio, pay off as much debt as you can. Get a part-time job if you have to. Pay off loans with the highest interest rates first. The money you save on interest can be put toward paying off other debts.