Home Equity Loan Requirements and Borrowing Limits – Forbes Advisor


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Home equity loans are fixed-rate loans with an amount based on the equity built up in your home. They’re given to you as a lump sum by the lender, and once disbursed, you pay interest on the loan amount until it’s fully paid off.

Home equity loans are often called second mortgages because it’s another loan payment to make on top of your primary mortgage debt, if you have one. But you can still get a home equity loan even if your home is paid off. Here’s what you should know about qualifying for a home equity loan.

How a Home Equity Loan Works

Home equity loans are a convenient way for you to take cash out of your home by borrowing against your home’s equity—the amount leftover after deducting your current mortgage balance from the value of your home. You’ll be charged a fixed interest rate that doesn’t change during the life of the loan. And you’re expected to pay interest on the entire balance of the loan, 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 house if you default.

Though some lenders may waive certain loan costs, most charge fees and closing costs. So take the time to compare more than just your monthly payment when shopping around.

Related: Best Home Equity Loan Lenders

Home Equity Loan Requirements

The interest rate you get on a home equity loan is based on several factors:

  • Income
  • Employment
  • Credit score
  • How much equity you have in your home
  • Debt-to-income (DTI) ratio

Credit Score

The higher your credit score, the more favorable your loan terms will be. Lenders usually require a minimum credit score of 660—and this requirement could be higher depending on the loan amount.

But don’t worry: If you fall below this threshold, there are steps you can take to improve your credit.

DTI

Your DTI ratio shows how much of your monthly income goes towards covering your existing debt obligations. It helps lenders determine whether you can afford to take on more debt. To qualify for a home equity loan, typically your DTI cannot be higher than 43%.

However, if you have bad credit, you’ll likely need a much lower DTI to be eligible.

Employment and Income Verification

Your lender will want to verify your employment and income by reviewing your last two W-2 forms as well as your most recent paycheck stubs.

If you’re self-employed, you’ll have to provide your federal income tax returns for the last two years. If you receive retirement income, the lender will want to see a retirement award letter or 401(k) distribution letter.

Home Equity Loan Borrowing Limits

The size of the home equity loan you qualify for also depends on your credit score. But in addition to this, the lender will consider how much your home is worth and the amount of equity you’ve built up.

Find Out How Much Your Home Is Worth With an Appraisal

A home appraisal is an analysis of your property from a certified or licensed appraiser hired 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 might also evaluate your property’s current market value using an Automated Valuation Model (AVM).

Ideally, the lender wants to see an appraised value that’s equal to or greater than the home equity loan amount. Smart home improvements can help increase your home’s appraisal value.

Calculate How Much Equity You Have in Your Home

You should have at least 20% equity in your home to qualify for a home equity loan, though some lenders will be more flexible on that ratio. To increase your equity, you need to either boost 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 establish how much equity you have. In this case, it would be the size of the home equity loan you have applied for and your existing mortgage balance versus your home’s value. 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 your home value.

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 down your current loan amount or hold off until your home’s value appreciates.

Some lenders might be willing to tolerate a CLTV at close to 90%, but that 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.

Cash-out Refinance

With a cash-out refinance, you’ll take out a loan for a higher amount than the balance of your current mortgage. After you have used the funds to pay this off, you’ll have the remainder—minus any closing costs—to use how you see fit.

You can typically qualify for cash-out refinancing with a credit score of 660 or a little less—but a score of at least 700 or will secure lower interest rates. Also, keep in mind that your monthly payments will increase because you’re paying off your old mortgage with a larger loan.

Personal Loan

The money from a personal loan can be used for any personal expense—including home improvements or consolidating your debts. Most personal loans are unsecured loans, meaning you don’t have to worry about putting up collateral.

But because of the heightened risk for the lender, these typically have higher interest rates than a home equity loan. Additionally, depending on the lender, the size of the personal loan you can get might 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 so you can ensure you’re getting the right deal for your situation. You could also talk to a qualified credit counselor to aid you in making the right decision.

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