One advantage of being a homeowner is the ability to build equity in your home. You can tap into that equity in the form of a home equity loan or line of credit to pay for home improvement projects, or to pay off other types of debt. Since a home equity line of credit tends to have a lower interest rate than many other types of credit, you can, for example, pay off medical bills or consolidate credit card debt, while paying less interest.
- The amount of your home equity loan or line of credit is based on your home’s equity.
- A home equity loan or line of credit doesn’t have to be used on home improvement projects; it can be used for debt consolidation, medical bills, student loans, or anything else.
- You will need a good credit score to get a good rate on a home equity loan or line of credit.
- Your debt-to-income ratio is a factor in determining approval for a home equity loan or line of credit.
“Home equity loans and lines of credit are essentially debt that you are leveraging by using the equity in your home,” James Goodwillie, co-owner at Brightleaf Mortgage in Richmond, Virgina, told The Balance by email.
The loan or line of credit is for a particular percentage of the equity you have. “For example, if your home is worth $300,000, and you owe $200,000, you technically have $100,000 of equity in your home,” Goodwillie said.
So how does this work and what are the requirements?
Home Equity Borrowing Requirements
A home equity loan is a fixed amount of money paid back over a specified amount of time in fixed monthly payments. On the other hand, a home equity line of credit (HELOC) is not a fixed amount. You can borrow up to an approved amount, similar to a credit card, and you pay interest only on the amount you borrow. Both have similar borrowing requirements.
Equity in the Home
The amount of equity in your home is a determining factor in whether you can borrow money against it, and if so, for what amount. It’s based on your loan-to value (LTV) ratio. “The loan-to-value ratio is just the total amount of debt on the home versus the appraised value of the home,” Goodwillie said. Using his example, let’s say your home is worth $300,000 and you owe $200,000. “The LTV would be 66.6% ($200,000/$300,000).”
He also said you could not borrow beyond 90% combined loan-to-value (CLTV), which includes all of the loans on the property. “In this particular example, you could open a home equity line up to $70,000, since $70,000 + $200,000 = $270,000, and then $270,000/$300,000 = 90%.”
The LTV ratio comes into play with first mortgages, too. If your down payment isn’t large enough to bring LTV down to 80%, most lenders will require you to pay private mortgage insurance or PMI.
A Good Credit Score
As with most financial transactions, a good or excellent credit score can make a significant difference. For a home equity loan or line of credit, a FICO score of at least 700 is good, although some lenders may accept a score of 640 or even lower. A score below this may be accepted by some lenders, but could result in you having to pay a higher interest rate.
|800 or higher||Exceptional||Well above average of U.S. credit scores; indicates exceptionally low risk|
|740-799||Very Good||Above average of U.S. credit scores; indicates the borrower is very dependable|
|670-739||Good||Near or slightly above average U.S. credit scores; most lenders consider this a good score|
|580-669||Fair||Below average of U.S. credit scores although many lenders will still provide credit to borrowers in this range|
|Less than 580||Poor||Credit scores well below average; indicates the borrower may be a risk.|
A Healthy Debt-to-Income Ratio
Your debt-to-income ratio (DTI) is also a factor lenders will consider. This refers to how much money you make monthly, compared to how many expenses you have. “Under 43% is the standard,” Goodwillie said. Some lenders may accept as much as a 47% DTI ratio; however, your lender will let you know their acceptable ratio.
Calculating your debt-to-income ratio is simple: Add up your monthly debt payments and divide by your gross monthly income. Multiply the result by 100 for a percentage. Here’s an example: A family has total monthly debt payments for a car, mortgage, and credit cards of $1,900 and gross monthly income (that’s income before taxes) of $6,500. The math is $1,900 / $6,500 = 0.292 x 100 = 29.2%. That’s healthy enough to qualify for a HELOC or home equity loan, assuming other requirements are met as well.
Should You Borrow Against Your Home Equity?
Now that you know whether or not you qualify to borrow against your home equity, another important decision is whether you should borrow or not.
“Depending on how long you are planning to stay in the home, it can be a valuable tool in tapping into the equity of your home, since you don’t pay all the closing costs like you would on a cash-out refinance,” Goodwillie said.
However, he said that there are two factors you should keep in mind. “First, it is more expensive—the rates are often much higher than the mortgage rates.”
Goodwillie said it’s important to remember that a HELOC or home equity loan will result in another lien against your home—just like a second mortgage. “So when you go to refinance in the future or sell your home, you have to deal with loan/debt companies that you are responsible for paying off, and this can lead to a more expensive and time-consuming process when that time comes.”
Alternatives to Borrowing Against Home Equity
There are alternatives to borrowing against your home’s equity to finance a home renovation or pay down debts. For example, you can use a credit card with a low interest rate, a personal loan, or a CD loan.
Another alternative is to seek a cash-out refinance, although that’s a more involved, and more expensive, process.
Frequently Asked Questions (FAQs)
Can you get a home equity loan with bad credit?
If your credit score is below the recommended range, you may still qualify for a home equity loan. However, your interest rate would be higher, so it’s advisable to try to improve your credit score before applying.
How many paychecks are usually needed to meet the income requirements for a home equity loan?
Your lender can tell you the specific number of pay stubs required, but expect to collect two or more. You will also likely need to provide tax statements and financial statements.
How long does it take to get approved for a home equity loan or line of credit?
The exact amount of time it takes for the home equity loan or line or credit to be approved varies by lender, but expect it to take 30-45 days. However, the lender will notify you when it has been approved or denied, and if it is approved, a closing date will be scheduled.