You may want to tap your home equity for any number of reasons, whether you’re ready to start a home renovation or buy an investment property. Your equity can provide a source of flexible funding with generally low interest rates through a home equity loan, among other financial products. But, like other loan products, you must meet the requirements to get a home equity loan.
Learn how the role of debt-to-income ratios, equity levels, and credit scores are among the factors that determine whether a lender may approve you for a home equity loan.
- Home equity loans are lump-sum loans secured by the equity in your home.
- Lenders prefer borrowers with good credit scores and low debt-to-income ratios.
- You generally need at least 20% equity in your home to be approved for a home equity loan.
- You usually cannot tap 100% of your equity.
What is a Home Equity Loan?
A home equity loan, also known as a second mortgage, is a lump-sum loan that uses your house as collateral. As a secured loan, home equity loans can offer more competitive rates than other financial products like personal loans or credit cards. Home equity loans typically have a fixed interest rate and a fixed payment term of five to 30 years, making them easy to work into your monthly budget.
Your home equity is essentially the amount of value in your home that you own, and that is not funded by a loan. Calculate it by subtracting what you owe on your home from its current market value. You can gain equity as you pay down your mortgage or as your home gains value.
Your mortgage payment is a combination of principal and interest payments. Only principal payments build equity. Your primary mortgage provider will detail how much you’ve paid in principal on your mortgage statements.
What Do You Need To Qualify For A Home Equity Loan?
A home equity loan operates similarly to a primary mortgage, and many requirements are the same. But since you’re not borrowing the entire cost of the home with a home equity loan, you may face a few unique requirements.
Lenders are looking for borrowers who have demonstrated financial responsibility and a low risk of defaulting on their loans. They look for:
- A credit score of at least 620: Borrowers with better credit scores usually get more attractive interest rates, but you may qualify even if your score in the ‘good’ range. Your good credit score demonstrates your ability to pay your bills on time.
- At least 20% equity in your home: Lenders want to see you have enough to borrow against without posing a risk. Having at least 20% equity means you also have a minimum of 80% loan-to-value ratio.
- Income history of at least two years: You’ll likely have to provide proof of income, such as through tax returns or pay stubs. You may be asked for a profit and loss statement if you’re self-employed.
- A low debt-to-income ratio (DTI): Lenders want to see that you’re not overextended, so they may require a certain debt-to-income ratio (DTI). Calculate your DTI by adding all your monthly debt payments and dividing them by your gross monthly income. Your required DTI will vary from lender to lender.
Once you apply for your home equity loan, your lender may order an appraisal to determine the current market value of your property. If your house has risen in value, you may have more equity than you realize. If your home value has decreased, your equity will be reduced.
Can I Borrow 100% of my Available Equity?
You cannot usually borrow 100% of your equity. Lenders will typically only lend you a portion of your equity. Generally, you can borrow up to 80% of your available equity.
Can I Have More than One Home Equity Loan?
You can have multiple home equity loans on one property. However, every loan will factor into the requirements for a new loan as lenders use the combined loan to value ratio (CLTV). The CLTV is calculated by deducting your home value from all existing loans, including your primary mortgage, other home equity loans, and home equity lines of credit. So, the amount you can borrow will be diminished with each new loan.
What Happens if I Default on my Home Equity Loan?
Since your home equity loan is secured using your house as collateral, failure to pay your loan could result in your lender foreclosing on your house. The lender would then sell the house to repay your debt. This is why it’s extremely important to be realistic about how much money you can afford to borrow and make all your payments on time.
Lenders look for borrowers who are lower risk, so they set these requirements for home equity loans. When applying for a home equity loan, you must show that you can repay your debts by meeting standards for credit scores, home equity levels, and more. Before applying for a loan, review your monthly expenses and calculate whether you can afford another loan payment. Increasing your credit score and paying off any other debts, makes you more attractive to lenders.