What You Need to Qualify for a Home Equity Loan

Home equity is one of the primary benefits of owning a home. If you can build equity in your home, you can borrow against it. Home equity can be a source of flexible funding with low interest rates, also known as home equity loans. Like other loans, there are requirements you must meet to qualify. The following is what you need to qualify for a home equity loan. 

What Is a Home Equity Loan?

Home equity refers to the difference between what your home is worth and the amount you owe on your mortgage. A home equity loan, also known as a second mortgage, is a loan whereby your home equity is the collateral. 

You receive a one-time payment from the lender and usually pay a fixed interest rate for a fixed payment term of five to thirty years. Because they are secured loans, home equity loans offer more competitive rates than other loans.

You can typically borrow up to 85% of your home equity. Therefore, the more home equity you have, the more you can borrow. The downside to home equity loans is if you default on the loan payments, you risk losing your home in foreclosure. 

Home Equity Loan Requirements

A home equity loan is similar to a primary mortgage and has many similar requirements. However, since you are borrowing against a house that already has debt obligations, requirements are stricter. 

The following are some of the requirements: 

Minimum Equity Percentage

You must have a minimum amount of equity to qualify for a home equity loan. Lenders use your home equity to calculate your loan-to-value ratio or LTV ratio, a metric they use to determine whether you can repay the loan. 

The loan-to-value ratio is the total debt amount on the home compared to its value. Therefore, if you have a mortgage debt of $200,000 and your home is valued at $250,000, your equity is 20% and your LTV is 80%. 

Most lenders require you to have a minimum equity percentage of 15% or an LTV ratio of 85%. However, many lenders will go beyond the minimum threshold. If the LTV ratio is higher than 90%, the FDIC recommends that lenders get mortgage insurance. 

You can build your home equity by paying your mortgage or making home improvements that increase the value of your house. 

Good Credit

A high credit score is paramount to meeting most lenders’ requirements for a home equity loan. If you meet other eligibility requirements, a credit score of 680 or higher should suffice for you to qualify for a home equity loan. 

However, many banks will set their minimum credit score for the loan at 620. 

Some lenders may extend home equity loans to people with a credit score of less than 620. On the other hand, the borrowers must have more equity in their homes and have less debt in comparison to their incomes. 

Therefore, if you want to take out a home equity loan, you should consider improving your credit score first. It will allow you to secure more favorable terms for the loan. 

Maximum Debt-to-Income (DTI) Ratio

Your debt-to-income ratio is a measure of your monthly debt payments relative to your monthly income. DTI is a crucial factor that lenders evaluate when considering a home equity loan application. 

The debt-to-income ratio for a home equity loan will vary depending on the lender. Some lenders will go as low as 35%, while others will allow a DTI as high as 50%. However, most lenders require you to have a DTI of 43% or less. 

To determine your debt-to-income ratio, you should sum up your monthly debt payments, and divvy them up by your gross monthly income. For example, if you have monthly auto loan payments of $400, student loan payments of $500, and mortgage payments of $1,600 with a total annual income of $75,000 ($6,250 monthly), you have a DTI of 40%. 

There are two ways to lower your debt-to-income ratio: pay off your debts as quickly as possible and reduce your monthly debt obligations or increase your income promptly. 

Income Requirements

Many lenders do not have specific requirements as it pertains to minimum income to qualify for a home equity loan. However, they will assess your income to ensure you make enough to repay the loan. 

Moreover, your income level will determine how much you can borrow. If two borrowers have the same debt-to-income ratio, the borrower with a higher income is more likely to qualify for the home equity loan. 

Therefore, you should prepare to provide income verification data at the lender’s request when applying for a home equity loan. These may include paystubs and W-2 tax forms. 

Reliable Payment History

Taking out a second mortgage is not only risky to you but also to the lending institution. Lenders want to minimize risk as much as possible, so they will evaluate your payment history to ensure minimal risk. 

Your overall payment history is part of your credit score, but lenders will look at your payment history more closely when assessing your home equity loan application. Even if you have a sufficient credit score, lenders will be less inclined to give you a home equity loan if you have a history of late payments. 

Should You Get A Home Equity Loan?

The above are the requirements of a home equity loan. After understanding them, you should seriously consider whether you should apply for a loan. 

You should get the loan if you will use it for expensive home improvements like renovations or additions. If you do, the interest on the loan is tax deductible. 

You should also consider the loan if you use it to consolidate high-interest loans. Because they are secured, home equity loans often have lower interest rates. 

You should get a home equity loan only if you can afford the extra monthly expense. If you cannot, it will break your budget and put you in a dangerous financial position. 

If you decide to get a home equity loan, meet the above requirements, make your application more eligible and qualify for the loan.