If you already own a home, you might know that building equity is one of the biggest advantages. With ahome equity loan or home equity line of credit, you can take advantage of the ownership stake in your home to financehome improvements, consolidate debt or pay for other big expenses.
A home equity loan is a lump sum that is paid back in fixed installments, while a HELOC is an ongoing line of credit from which you can withdraw funds. Both are good options for homeowners in need of access to cash, but there’s always a risk when you borrow against your home. If you default on your payments, you run the risk of losing your property.
While getting home equity financing is a fairly simple process, it’s important to review the details before applying. Lenders have standard criteria that homeowners must follow to qualify for either loan, as well as their own specific requirements. Make sure to compare different lenders and take a look at the application requirements.
Below, we’ll cover the general criteria for home equity financing to help you get started.
How do home equity loans and HELOCs work?
Home equity loans and HELOCs are secured loans that act as second mortgages. Because they use your property as collateral for the debt, the interest rates for home equity loans and HELOCs tend to be lower than other loans like personal loans or credit cards.
“Both options allow homeowners to maintain their existing primary mortgage which, for most homeowners, were obtained when rates were much lower,” says Rob Cook, vice president of marketing, digital and analytics for Discover Home Loans.
A home equity loan provides you with a one-time lump sum of cash. Over a period of five years or longer, you’ll pay back the loan at a fixed rate. Your monthly payment will remain the same even if rates change.
A HELOC is a flexible lending option, meaning you can withdraw funds as needed. While there’s a limit to how much you can take out at once, you’ll only pay interest on what you’ve borrowed during the draw period. Unlike home equity loans, interest rates for HELOCs are often variable, meaning your monthly payments could be unpredictable.
Before borrowing with a home equity product, remember: The loan is guaranteed by your home as collateral. If you’re unable to cover your monthly payments, the lender can foreclose on your home.
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How much can you borrow with a home equity loan or HELOC?
Lenders typically allow a homeowner to borrow up to 80% to 85% of their home’s value. This doesn’t include the remainder of their mortgage balance.
You can determine how much money you’ll be able to obtain from a home equity loan by starting with the current value of the home. If, for example, your home is worth $300,000 and a bank lender allows you to borrow up to 85% of the value of your home, you simply multiply the two values to get the maximum amount you can borrow, which is $255,000.
$300,000 x 0.85 = $255,000
But if you have a balance on your mortgage of $200,000, you need to subtract it from the $255,000 maximum the bank will let you borrow. That means you can borrow $55,000 for a HELOC.
$255,000 – $200,000 = $55,000
Requirements to borrow home equity
The requirements to qualify for either a home equity loan or HELOC are similar. Although each lender has its own qualifications, the following checklist provides general criteria to help you get started.
1. Have at least 15% equity in your home
Home equity is the amount of the home that you own. The amount of equity includes the amount of your down payment, plus all the mortgage payments you’ve made over the years.
Subtract the loans you owe such as your mortgage from the appraised value, which comes from your county appraisal district, to determine the amount of your equity.
2. Your loan-to-value ratio shouldn’t exceed 80%
The loan-to-value ratio, or LTV, is used by lenders to determine whether you qualify for a home equity loan. It’s derived from dividing the current loan balance by the home’s appraised value and expressed as a percentage value. In the above example, if your loan balance is $200,000 and your home is appraised at $300,000, divide the balance by the appraisal and you get 0.67, or 67%. Therefore, your LTV is 67%, which means you have 33% of equity in your home.
The LTV ratio shouldn’t exceed 80% of the home’s value. Mortgage lenders such as Fannie Mae and Freddie Mac can approve home loans only up to a maximum ratio of 80%. Having an LTV ratio of less than 80% is considered good, and if you have an LTV ratio higher than 80%, you may be declined for a loan. Worse yet, at that level, you may need to buy mortgage insurance, which protects the lender in the event that you default on your loan and the lender needs to foreclose on your home.
A combined loan-to-value ratio, or CLTV ratio, is the ratio of all secured loans on a home to the value of the home. It includes all the loans connected to your home, such as your current first mortgage plus either a home equity loan or HELOC that you’re seeking. The CLTV is used by lenders to determine the homebuyer’s risk of default when more than one loan is used. You can typically borrow up to a CLTV ratio of 85%. That means the total of your mortgage and your desired loan can’t exceed 85% of your home’s value.
A higher down payment amount and paying down your mortgage are two ways to lower your LTV. Having a lower LTV means less risk for mortgage lenders.
Homeowners can build home equity through various options. A larger down payment of more than 20% will increase the amount of equity. Higher appraisals from a county assessor that increases the value of the home will also yield more equity. Making extra payments towards your mortgage will also increase your equity because you owe less money.
3. Have a credit score in the mid-600s or higher
A good credit score will make you eligible for a loan at a lower interest rate, which will save you a substantial amount of money over the life of the loan. Lenders also use your credit score to determine the likelihood that you’ll repay the loan on time, so a better score will improve your chances of getting approved for a loan with better terms. A credit score of 680 will qualify you for a loan with amenable terms provided you also meet equity requirements. A score of at least 700 will make you eligible to receive a loan at lower interest rates.
4. Your debt level shouldn’t exceed 43%
Your debt level is determined by your debt-to-income ratio, which is simply your total monthly debt payments divided by your total gross monthly income. The DTI ratio helps lenders determine if you’re capable of paying back your loan on time and of making consistent monthly payments.
In determining DTI, lenders tally the total monthly payment for the house -- mortgage principal, interest, taxes, homeowners insurance, direct liens and homeowner association dues -- and any other outstanding debt. That total debt is then divided by your monthly gross income to get your DTI ratio.
Some lenders prefer that your monthly debts don’t exceed 36% of your gross monthly income, but many others are willing to go as high as 43%. If your DTI ratio is higher than 43%, consider paying down your debts first to the point where your DTI ratio is less than 43%.
Should you get a home equity loan or a HELOC?
That depends. Home equity loans and HELOCs can be used for similar purposes, but they have some important differences. Neither product is necessarily superior, so consider your own expenses and goals.
If you need to fund a single project with a set cost, a home equity loan may be the better option, especially if the predictability of a fixed interest rate and monthly payment appeals to you. A HELOC may make more sense if you want flexible access to funds over a long period of time rather than an upfront sum of cash.
You should get a HELOC if:
- You need access to credit for an extended period of time. HELOCs have a draw period that typically lasts five to 10 years.
- You need more time to repay the loan amount. The repayment period for HELOCs ranges from 10 to 20 years.
- You aren’t sure how much money you’ll need. HELOCs give you the flexibility to withdraw money in installments and not all at once. During the draw period, you can borrow up to a limit -- only paying interest on what you borrow -- as many times as you like. This makes HELOCs a good option for managing variable or unpredictable costs.
You should get a home equity loan if:
- You want a predictable monthly repayment schedule. Unlike variable-rate HELOCs, home equity loans have fixed interest rates, making it relatively easy to factor into your monthly budget.
- You have a specific expense in mind. You receive 100% of the funds from a home equity loan upfront, which can be useful if you need a set amount of cash to cover a home improvement project, tuition costs or another need.
Alternatives to home equity loans and HELOCs
A home equity loan or HELOC can be a good way to use your home equity to fund large expenses, but there are other financing options that may be a better fit for certain situations. Some alternatives you may want to consider include:
- A cash-out refinance. With a cash-out refinance, you are cashing out the equity you’ve built in your home over the years. You replace your existing mortgage with a new, larger one and pocket the difference as cash. The money you borrow is rolled into your new mortgage, so you’ll only have one monthly payment. A cash-out refinance might be a good option provided you can get a better rate than the one on your existing mortgage -- but today’s high mortgage rates make that difficult.
- A personal loan. If you only need to borrow a small amount of money, a personal loan might be a better fit than a home equity loan or HELOC. The interest rate will typically be higher and the loan term shorter, but the debt is usually unsecured and you won’t have to go through a home appraisal or pay closing costs.
- A balance transfer credit card. If the main reason you’re looking to take out a loan is to consolidate other high-interest debt, balance transfer credit cards let you combine your debts into one card that has a long 0% APR introductory period. If you can pay off the debt before the 0% introductory period ends, you’ll get rid of your debt faster. Just be sure to plan ahead carefully: If you’re still carrying a balance by the end of the introductory period, you’ll be charged the regular credit card APR, which can be high.
The bottom line
A home equity loan and a HELOC are two ways you can tap into the equity of your home. To qualify for either loan with reasonable terms, you should have at least 15% to 20% of equity in your home, a LTV ratio of 80% or lower, a credit score of at least 620 (the higher, the better) and a DTI ratio no higher than 43%.
Couple these criteria with a reliable payment history and source of income to ensure that you can be eligible for a home equity loan or HELOC. Specific qualifications may vary between lenders so take the time to shop around and compare.
FAQs
Some lenders will provide a home equity loan or HELOC if you don’t have a job or are retired, but instead have regular income from a retirement account such as a pension. The income can also come from a spouse or partner’s employer, government assistance or alimony.
Lenders are typically seeking at least 15% in equity from the home since many of them will allow you to borrow a maximum of 85% for the value of the home for either a HELOC or home equity loan.
Lenders prefer good credit scores that are 680 or higher if you have enough equity in the home. The majority of lenders seek a credit score of at least 700. A higher credit score means less risk for a bank or mortgage company, which means interest rates are often lower.
You can improve your credit score before you apply for a home equity loan by making payments on time, paying down the amount that’s owed on credit cards and avoiding taking out any new loans from buying a new or used car or purchases such as major high-end appliances like refrigerators and ranges.
