One of the biggest benefits of homeownership is the ability to build equity — and to borrow against it. When you build up enough of it, typically by paying down your mortgage or investing in home improvement projects, you can unlock the equity in your home through a home equity loan or a home equity line of credit, or HELOC.
Requirements vary by lender, but there are standard criteria that are necessary to qualify for a HELOC or home equity loan.
What are HELOCs and home equity loans?
Both HELOCs and home equity loans allow you to borrow money from the equity you have in your home. However, they both allow you to borrow money with different terms and requirements. Here’s the key information on both HELOCs and home equity loans.
HELOC
A HELOC is a revolving line of credit that allows you to borrow against the equity you’ve built up in your home. During the draw period, you can borrow funds up to a certain limit set by the lender, carry a monthly balance and make minimum payments, much like a credit card.
The draw period typically lasts about 10 years, during which you may only be required to make payments towards interest. Afterward, you’ll enter the repayment period, which is usually 20 years, and make monthly payments towards the principal and interest.
Here are several benefits of a HELOC:
- Flexibility: A home equity line of credit allows for flexibility during both the draw and repayment periods, enabling you to borrow only what you need up to 85 percent of your home’s value, minus outstanding mortgage payments.
- Qualify for a low APR: HELOCs can also have lower interest rates and lower initial costs compared to credit cards.
- Few restrictions: You are generally free to use the funds as you wish, whether you need extra cash for home improvements, debt consolidation or even travel.
Home equity loan
Similar to a HELOC, a home equity loan allows homeowners to borrow against the equity in their home. However, a home equity loan is a fixed amount of money paid out in one lump sum. Homeowners repay the loan in fixed installments over a predetermined period. Home equity loans are typically fixed-rate while HELOCs are variable-rate.
The benefits of a home equity loan include:
- Predictable payments: Monthly payments will remain the same with a fixed interest rate.
- Lower borrowing costs: Interest rates for a home equity loan are typically lower than interest rates for credit cards or unsecured personal loans.
- Longer terms: A home equity loan term can range from five to 30 years.
Requirements to borrow from home equity
Home equity loans and HELOCs have their own sets of pros and cons, so consider your needs and how each option would fit your budget and lifestyle. Regardless of which type of loan you choose, home equity loan requirements and HELOC requirements are typically the same:
- A minimum percentage of equity in your home
- Good credit
- Low debt-to-income (DTI) ratio
- Sufficient income
- Reliable payment history
1. At least 15 percent 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 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 mortgage 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. Since your LTV ratio is 33 percent, you have 67 percent equity in your home.
This also determines how much you can borrow. You can usually borrow up to a combined loan-to-value ratio (CLTV) of 85 percent, meaning the sum of your mortgage and your desired home equity loan can make up no more than 85 percent of your home’s value. In the above example, 85 percent of the home’s value is $382,500. If you subtract your mortgage balance, that leaves you with $232,500 of equity to borrow with a loan.
There are a few ways to build home equity:
- Pay your mortgage bill: Paying down your mortgage will increase the amount of equity you have in your home, and making more than the minimum payment will increase that equity even faster.
- Make home improvements: You can also complete renovations that increase the home’s value — although keep in mind that if you wait to make home renovations using a home equity loan, you could see tax benefits.
Why it’s important
Typically, lenders will only approve a home equity loan or HELOC with an LTV ratio or CLTV ratio of up to 85 percent — meaning you have 15 percent equity in your home. Maintaining at least 15 percent 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. If you max out your financing, selling your home could be more difficult.
2. A credit score in the mid-600s
A favorable credit score is essential to meet most banks’ approval requirements. A credit score of 680 or higher will most likely qualify you for a loan as long as you also meet equity requirements, but a credit score of at least 700 is preferred by most lenders. In some cases, homeowners with credit scores of 620 to 679 may also be approved.
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. Bad-credit home equity loans and HELOCs will have high interest rates and lower loan amounts, and they may have shorter terms.
Before applying for a home equity product, take steps to improve your credit score. This could involve making timely payments on loans or credit cards, paying off as much debt as possible or avoiding new credit card applications.
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.
3. A DTI ratio of no more than 43 percent
Your debt-to-income (DTI) ratio 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 be willing to go as high as 43 percent or 50 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 your 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 a home equity loan, calculate your DTI. If you’re above your potential lender’s optimum ratio, pay off as much debt as you can. Try starting with the debt avalanche method, where you first pay off debts with the highest interest rates. The money you save on interest can be put toward paying off other debts.
Jerry Schiano, CEO of home equity lender Spring EQ, also recommends extending the term of any outstanding loans you hold, which will reduce your monthly installment payments on the debt. However, keep in mind that extending the term of a loan could increase the amount you pay in interest during the life of the loan.
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.
4. An adequate income
While not all lenders list specific income requirements for their home equity products, many will evaluate your income to make sure you make enough money to repay your loan. Your income level may also determine how much you are able to borrow. More critically, having a higher income or finding ways to boost that income prior to applying for a home equity loan will also improve your DTI ratio.
Be prepared to provide income verification information when you apply for your loan; examples of documents you may be asked for are W-2s and paystubs.
Why it’s important
A steady income indicates to lenders that you’ll be able to make payments on your loan. Plus, the higher your income, the easier it may be to lower your debt-to-income ratio.
5. A reliable payment history
When deciding whether to issue loans, lenders want to make sure that they’re not taking on too much risk. One of the main ways to do this is to evaluate potential borrowers’ payment history.
While payment history is folded into your overall credit score, lenders may look closer to see how often you pay your bills on time. If you have a history of late payments, lenders may be less willing to lend to you, even if you have an otherwise decent credit score. This is because they don’t want to risk losing money in the event that you can’t pay your bills.
This is especially true with home equity loans and HELOCs, since these are technically second mortgages — meaning the lender will be second in line for payment should your home be foreclosed.
Why it’s important
If you have a history of late payments or accounts in collections, lenders may be less willing to lend to you since they see you as a higher risk. Make at least the minimum payments on credit card accounts or set up automatic payments before applying for a home equity loan to give yourself the best chances at approval.
Should you get a home equity loan or HELOC?
Taking out a home equity loan or HELOC can be a wise decision if you need money to fund a home improvement project or consolidate high-interest debt. Since the loans are secured by your home, the interest rate is usually lower compared to unsecured loan products such as credit cards or personal loans. For example, home equity loan rates range between 3 percent and 12 percent, depending on the lender, loan amount and the creditworthiness of the borrower, while the average credit card rate is above 16 percent.
In addition, if you use the money from a home equity loan to “buy, build or substantially improve” your home, as defined by the IRS, you may be able to deduct the interest on the loan from your taxes.
However, one major downside to consider is that if you default on the home equity loan, the lender can foreclose on your home. Before you get a loan that uses your home as collateral, make sure you have a solid repayment plan.
Alternatives to home equity loans and HELOCs
Although taking out a home equity loan can be a good financial decision, it’s not the best option for everyone.
- Personal loans: A personal loan is a lump sum of money you receive from a lender; it comes with a fixed interest rate and fixed monthly payment. Terms usually last from one to seven years. Although most personal loans are unsecured, secured personal loans exist. A personal loan can be a better option if you can secure a lower interest rate or don’t want to risk losing your home with a home equity loan.
- 0 percent intro APR credit cards: When you use a 0 percent intro APR credit card, you can avoid paying interest on purchases during a promotional period that often lasts between 6 and 21 months. Using this option instead of a home equity loan can help you avoid interest charges altogether if you have a short-term home renovation project.
- CD loans: CD loans are secured by your certificate of deposit (CD) account. The lender typically charges you two to three percentage points above your current CD’s interest rate. This can be a better option if you’re looking to secure a lower interest rate than a home equity loan.
- Family loans: Family loans are loans you get from family members. This can be a good option if a family member is willing to let you borrow money with no or low borrowing costs. However, keep in mind that not repaying the loan might harm your relationship with your relative.
HELOC and home equity loan FAQ
If you don’t have a job, getting a home equity loan or HELOC might be hard — you might not meet the lender’s income requirements. However, you might be able to qualify for a home equity loan if you have other sources of income, such as a pension or retirement distributions, Social Security or long-term disability payments, rental income or child or spousal support. A lender might also consider a co-signer’s or co-borrower’s income if you have one.
For a home equity loan or HELOC, lenders typically require you to have at least 15 percent to 20 percent equity in your home. For example, if your home has a market value of $200,000, lenders usually require that you have between $30,000 and $40,000 worth of equity in it.
Although different lenders have various credit score requirements, most typically require you to have a minimum credit score of 620.
