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.
How to get a home equity loan
Each loan has its own set of pros and cons, so it’s important to consider your needs and how each option would fit your budget and lifestyle.
Before you apply for a loan, you should:
- Have at least 15 to 20 percent equity in your home.
- Have a credit score of 620 or higher for higher likelihood of approval.
- Have a debt-to-income ratio between 43 to 50 percent.
1. Have at least 15-20 percent equity in your home
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.
2. Check your credit score
Having equity is not enough to secure a loan from most banks. A favorable credit score also is essential in order to meet most banks’ requirements for a HELOC.
Alex Shekhtman, a 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 might still be able to qualify for a home equity loan, but lenders may require the borrower have more equity in their home and carry less debt relative to their income.
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. Have a debt-to-income ratio between 43 to 50 percent
Your debt-to-income ratio, or DTI, is also a factor lenders consider with home equity loan applications. The lower the percentage, the better. The qualifying DTI ratio varies from lender to lender, but some require that your monthly debts eat up less than 36 percent of your gross monthly income. Other lenders are willing to go as high as 43 percent for your DTI.
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. If you’re not sure how best to apply your extra money, look for snowball and avalanche debt payment plans; these offer simple instructions on the order in which to pay your debts.
Other factors to consider
You can also improve your home equity loan approval odds and term amounts in a handful of other ways, including:
- Providing proof of income to show you can repay the loan
- Having a healthy overall credit history
- Having a solid history of paying your bills on time
Even if your credit score isn’t perfect or your debt-to-income ratio is on the verge of being too high, you may still have a chance to be approved for a home equity line of credit if you are successful in demonstrating these factors.
Lenders use a mix of factors to determine whether you can be approved for a home equity line of credit. One of the major factors is income, which will be scrutinized to make sure you’ll be able to repay the loan. A higher income can help cancel out the appearance of debt and give you a debt-to-income ratio.
While your credit score is factored into the bank’s decision to issue a HELOC, your broader credit history also affects your odds of being approved. For example, if you carry an exorbitant amount of debt, your application may be denied even if your credit score is above 750.
If you’re in the process of rebuilding your credit score and your credit history reveals a steady incline from the 500s (or lower) into the mid-600s or higher, you have a better chance of approval, provided you don’t have a mountain of debt to contend with.
You can improve your HELOC approval odds — as well as your loan terms — by maintaining a record of paying your bills on time. A pattern of timely payments will show the lender that you’re a reliable borrower. You may even be able to get a loan with a few missed payments on your credit history, but you’ll need to show your lender that your recent payment history is solid.
2020 federal and state requirements for home equity loans
All lenders must follow state and federal rules when lending money. While federal rules are the same everywhere, state rules can vary.
Banks generally allow you to take only up to 85 percent of equity out of your house. If your home is a rental or investment property, this number drops to 75 percent. One of the federal rules that changed in 2018 is in regard to the tax deductions you can get for the interest on your home equity loan. Now, only the interest for purchases used to build or improve the home you are securing is deductible.
The biggest differences from state to state are more about the cap on interest rates. High-risk lenders may offer a high interest rate equity loan though some states cap the maximum interest that can be charged.
Lenders are not all the same, and the offers that you get will depend on the lender you work with. One factor might be your relationship with the bank. If you have money in the bank or your primary mortgage is with the bank, there is often a discount in interest rate for existing customers. Credit unions where you are a member may also offer some lending discounts.