The 3 most important requirements to borrow from home equity

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Tapping home equity can be a smart way to borrow cash to pay for home improvements, pay off high-interest debt or fund other large expenses. If you have a significant amount of equity in your home, either because you’ve paid down your mortgage or because the market value of your home has increased substantially above the balance you owe on the property, you may be able to obtain a sizable loan.

What is a home equity loan? 

A home equity loan is a second mortgage against your home, the proceeds from which are paid out in a lump sum. The loan is secured against your home, and once you receive the money, you start repaying it right away in monthly installments with a fixed interest rate, just like your original mortgage.

In this way, home equity loans are similar to personal loans — both can be used for nearly any purpose, and both have fixed APRs. However, because home equity loans use your home as collateral, they often come with lower interest rates.

Why get a home equity loan?

Home equity loans can be helpful when you need a large amount of money to pay for home improvements or debt consolidation. And because they usually have lower interest rates than other types of unsecured debt like credit cards or personal loans, they may be one of the most affordable ways to finance large expenses.

There may also be some tax benefits associated with a home equity loan. The IRS allows homeowners to deduct interest on home equity loans from their taxes if the money was spent on substantial home improvements.

What are home equity requirements?

There are three ways to tap into your home’s equity: a home equity loan, home equity line of credit or cash-out refinance.

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. Regardless of which type of loan you choose, you’ll typically want to meet three base requirements:

Have at least 15 to 20 percent equity in your home

Equity is the difference between how much you owe on your mortgage and the home’s market value. Lenders use this number to calculate what’s known as the loan-to-value ratio, or LTV, a factor that helps determine whether you qualify for a home equity loan.

To determine your LTV, divide your current loan balance by the appraised value of your home. For instance, if your loan balance is $150,000 and an appraiser values your home at $450,000, you would divide the balance by the appraisal and get 0.33, or 33 percent. This is your LTV ratio.

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.

Why it’s important: Typically, lenders will only approve a home equity loan or HELOC with a loan-to-value ratio or combined loan-to-value ratio of up to 80 percent — meaning you have 20 percent equity in your home. Maintaining at least 15 to 20 percent equity in your home is also important in the event that the real estate market experiences a downturn and the value of your property suddenly declines to a level much closer to the outstanding balance you owe on the mortgage, says Ralph DiBugnara, president of Home Qualified. If you max out your financing, selling your home could be more difficult.

Have a credit score in the mid-600s

Having enough equity is not the only important consideration for securing a loan. A favorable credit score is also essential in order to meet most banks’ approval requirements.

For those who have poor credit or a lot of outstanding debt, it may be more difficult to secure a home equity loan.

A credit score above 700 will most likely qualify you for a loan as long as you also meet equity requirements. Homeowners with credit scores of 621 to 699 might be approved, but most likely at higher interest rates.

Some lenders also extend loans to those with scores below 620, but these lenders may require the borrower to have more equity in their home and carry less debt relative to their income.

Why it’s important: Having a good credit score will help you secure more favorable interest rates, saving you a substantial amount of money over the life of the loan. In addition, lenders use your credit score to predict how likely you are to repay the loan, so a better score will improve your odds of approval.

Have a debt-to-income ratio of 43 percent or lower

Your debt-to-income ratio, or DTI, is yet another factor that lenders consider when reviewing a home equity loan application. The lower your DTI percentage, the better.

Qualifying DTI ratios will vary from lender to lender. Some require that your monthly debts eat up less than 36 percent of your gross monthly income, while other lenders may still be willing to go as high as 43 percent.

To determine 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.

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. Try starting with the debt avalanche method, where you pay off loans with the highest interest rates first. The money you save on interest can be put toward paying off other debts. Jerry Schiano, CEO of Spring EQ, also recommends extending the term of any outstanding loans you hold, which will reduce your monthly installment payments on the debt.

Why it’s important: Decreasing your debt-to-income ratio will improve your odds of qualifying for a home equity loan. Paying down existing debt will also boost your overall financial picture, helping you qualify for better rates on loans down the line.

Other factors to consider

While the factors above are the most common things lenders look at, some lenders may have other requirements, including:

  • Income. Lenders may scrutinize your income to make sure you’ll be able to repay the loan. A higher income can give you a better debt-to-income ratio.
  • Credit history. While your credit score is one of the most important factors in the bank’s decision to issue a loan, 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.
  • Payment history. You can improve your approval odds and 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.

It’s also important to note that all lenders are required to follow state and federal rules when it comes to lending money. Most significantly, limits on interest rates are different from one state to the next.

In addition, some federal rules have changed over the years. For instance, in 2018, the tax deductions available for the interest paid on a home equity loan were reduced substantially. Now, the only time the interest can be deducted is when the money is used to build or improve the property.

Next steps

If you’re still interested in pursuing a home equity loan or HELOC, it’s always a good idea to shop around with multiple lenders to compare interest rates, fees and terms. Bankrate’s list of the best home equity loans may be a good place to start, although it’s also worthwhile to investigate options from your local bank, as having an existing relationship could help your chances at approval. Additionally, take advantage of prequalification offers where available — lenders that offer prequalification allow you to check what rates you qualify for without going through a hard credit check.

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