Home Equity Loan Requirements and Borrowing Limits – Forbes Advisor
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Home equity loans are fixed rate loans whose amount is based on the equity accumulated in your home. They are given to you as a lump sum by the lender, and once disbursed, you pay interest on the loan amount until it is fully repaid.
Home equity loans are often referred to as second mortgages because they are another loan payment to be made on top of your primary mortgage debt, if you have any. But you can still get a home loan even if your house is paid off. Here’s what you need to know about qualifying for a home equity loan.
How a home equity loan works
Home equity loans are a convenient way for you to get money out of your home by borrowing against the equity in your home, which is the amount left over after you deduct your current mortgage balance from the value of your home. You will be charged a fixed interest rate that does not change for the term of the loan. And you’re expected to pay interest on the entire loan balance, even if you don’t use all of it.
Keep in mind that a home equity loan is secured by your home, which means the lender could foreclose on your home if you default.
Although some lenders may waive some loan fees, most charge fees and closing costs. So take the time to compare more than your monthly payment when shopping.
Related: Best home equity lenders
Home equity loan requirements
The interest rate you get on a home equity loan is based on several factors:
- Credit score
- How much equity do you have in your home
- Debt-to-income ratio (DTI)
The higher your credit score, the more favorable your loan terms will be. Lenders generally require a minimum credit score of 660, and this requirement may be higher depending on the amount of the loan.
But don’t worry: if you fall below this threshold, there are steps you can take to improve your credit.
Your DTI ratio shows how much of your monthly income is used to cover your existing debts. This helps lenders determine if you can afford to take on more debt. To qualify for a home equity loan, your DTI generally cannot exceed 43%.
However, if you have bad credit, you will likely need a much lower DTI to qualify.
Verification of employment and income
Your lender will want to verify your employment and income by reviewing your last two W-2 forms as well as your most recent pay stubs.
If you are self-employed, you will need to provide your federal income tax returns for the past two years. If you are receiving retirement income, the lender will want to see a retirement allocation letter or 401(k) distribution letter.
Borrowing limits on home equity
The amount of home equity loan you qualify for also depends on your credit score. But on top of that, the lender will consider the value of your home and the equity you have accumulated.
Find out how much your home is worth with an appraisal
A property appraisal is an analysis of your property by a licensed or licensed appraiser engaged by the lender during the home equity loan process to determine its value. The lender needs an accurate appraisal of the property to help determine your loan amount.
In addition to scheduling an appraisal, lenders can also assess your property’s current market value using an Automated Valuation Model (AVM).
Ideally, the lender wants to see an appraised value equal to or greater than the home equity loan amount. Smart home upgrades can help increase your home’s appraisal value.
Calculate the equity in your home
You must have at least 20% equity in your home to qualify for a home equity loan, although some lenders are more flexible on this ratio. To increase your equity, you must either increase the assessed value of your home or decrease the amount you still owe on your mortgage.
Lenders calculate your loan-to-value (LTV) ratio to determine how much equity you have. In this case, it would be the size of the home equity loan you applied for and the balance of your current mortgage compared to the value of your home. This is called a combined loan-to-value ratio (CLTV). CLTV is calculated by taking your existing mortgage balance(s) plus your desired loan amount, divided by the value of your home.
Most lenders require your CLTV to be 85% or less for a home equity loan. If your CLTV is too high, you can either pay off your current loan amount or wait for the value of your home to appreciate.
Some lenders might be willing to tolerate a CLTV close to 90%, but this will depend on your loan amount and credit score.
Alternatives to a home equity loan
Some lenders may not offer home equity loans. If you can’t find one that works for you, here are some other options to consider.
Refinancing by collection
With a cash refinance, you will take out a loan for more than your current mortgage balance. Once you’ve used the funds to pay for that, you’ll have the rest, less closing costs, to use as you see fit.
You can usually qualify for a refinance with a credit score of 660 or slightly lower, but a score of at least 700 or will guarantee lower interest rates. Also remember that your monthly payments will increase because you are paying off your old mortgage with a larger loan.
Money from a personal loan can be used for any personal expense, including improving your home or consolidating your debts. Most personal loans are unsecured, which means you don’t have to worry about providing collateral.
But due to the increased risk for the lender, these usually have higher interest rates than a home equity loan. Also, depending on the lender, the personal loan amount you can get may not be enough to fully cover the cost of a new home or even a down payment.
Related: Personal Loan Vs. Home Equity Loan
Weigh your options
Before taking out a home equity loan, always compare options from multiple lenders to make sure you’re getting the right deal for your situation. You can also talk to a qualified credit counselor to help you make the right decision.