Tapping home equity can be a cost-effective way for homeowners to borrow cash to fund home improvement projects or pay off higher-interest debt. If you have substantial equity in your home — either through paying down your mortgage or a spike in your home’s value — 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.
Here are three things you should do before you apply for a loan:
- Determine how much equity you have.
- Check your credit score.
- Look at your debt-to-income ratio.
1. Determine how much equity you have
Your 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 determining factor in whether you’re approved 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. By dividing the balance by the appraisal, you get 0.33, or 33 percent. This is your LTV.
Determining your home’s value requires 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 — either in a lump sum or as a line of credit — with 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 amount. 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 to be approved for a HELOC.
2. Check your credit score
Home equity itself is not enough to secure a loan from most banks. A favorable credit score is essential.
Alex Shekhtman, mortgage broker at LBC Mortgage in Los Angeles, explains 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, given that the equity requirements are met. Scores in the 699 to 621 range might get approval but will likely face higher interest rates. Those with scores below 620 probably won’t qualify for an unsecured loan.
You can get your credit report and score for free with 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.
Review your credit reports to make sure there are no errors on them. If you find a mistake, like a late payment or a fraudulent charge, report the problem to the bureau that’s showing the information. Your score likely will improve once the errors are removed. Consumers are entitled to a free credit report every year from each of the three main credit reporting agencies: Experian, TransUnion and Equifax.
3. Look at your debt-to-income ratio
Your debt-to-income ratio, or DTI, is also part of the qualification equation. The lower the percentage, the better. The maximum allowed DTI varies from lender to lender, but most require your DTI to be under 50 percent.
Lenders will add up the total monthly payment for the house, which includes principal, interest, taxes, homeowners insurance, direct liens and homeowners association dues, along with any other outstanding debt that is a legal liability.
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, to come up with your DTI.
You can improve your DTI by earning more money, lowering your debt or doing both. Before you apply, be sure to calculate your DTI. If you’re over the limit, then try to pay off as much as you can or consider a part-time job. Pay off loans with the highest interest rates first; the money you save on interest can be put toward paying off any other debt you might have.