Are you a homeowner looking to fund a renovation or make a major purchase? If you have sufficient equity in your home, a home equity loan could be a great solution for you.
But first, make sure you understand the typical home equity loan requirements to determine if you’re an ideal candidate. Read on to learn how these loans work – and what to expect if you apply for one.
Key Takeaways:
- A home equity loan is a type of second mortgage that allows homeowners to borrow money using the equity in their homes.
- Eligibility requirements for home equity loans vary by lender, but to qualify for a home equity loan, you must have sufficient equity in your home and will likely need a credit score of at least 620 and a debt-to-income ratio (DTI) of 43% or below.
- Most lenders allow you to tap into only 80% of your home’s current value.
What Is A Home Equity Loan?
Home equity represents the portion of your home’s value that you own. It’s the difference between what your home is worth and how much you owe on your mortgage. As you pay down your mortgage balance, or when your home increases in value, your equity also increases.
A home equity loan is a type of second mortgage that allows you to tap into that equity and turn it into cash. If you need a large sum of money to pay off a debt, make a major purchase, or fund home renovations, a home equity loan could be a valuable financing tool.
When you take out a home equity loan, you’ll receive a lump-sum payment, and then you’ll start making monthly payments for a period of years until the loan is paid off.
The loan is what is known as a secured loan – meaning you provide your home’s equity as collateral for the loan. This arrangement makes the loan less risky for lenders, so they’re usually willing to provide more favorable loan terms than they would for an unsecured loan. This also means, however, that if you fail to make the payments, you could lose your home in foreclosure.
Unsecured loans, such as personal loans, offer cash without requiring collateral. Since these loans are riskier for lenders, you can expect to pay higher interest rates and receive a smaller amount of money than you would with a home equity loan.
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Home Equity Loan Qualifications: At A Glance
To qualify for a home equity loan, you must have sufficient equity in your home. Consider these general requirements for home equity loans from most lenders:
Home Equity Loan Requirements
| Credit Score | 620 |
| Debt-To-Income Ratio (DTI) | 43% or below |
| Borrowing Limit | Typically, the home equity loan amount combined with the primary mortgage cannot exceed 80% of your home’s appraised value. You must have sufficient equity to be approved for a home equity loan. |
| Closing Costs | 2% – 6% of the loan amount |
Remember, eligibility for home equity loans can vary by lender.
Home Equity Loan Qualifications: A Detailed Overview
Let’s dive into the ins and outs of home equity loan requirements:
Credit Score
Your credit score is one of the most important factors lenders consider during the application process. Generally, you will need a credit score of at least 620 to receive a home equity loan from most major lenders. Some lenders require applicants to have an even higher credit score.
Your credit score helps lenders determine your ability and likelihood to pay back a loan.
Several factors influence your credit score, including:
- Payment history
- Credit utilization (how much of your available credit you’re using)
- Length of credit history
- Amount of new credit
- Mix of credit sources
A higher score can increase your chances of securing a loan with more favorable terms. For example, if you have a high credit score, you may qualify for a loan with a lower interest rate.
Debt-To-Income Ratio (DTI)
Your debt-to-income ratio (DTI) is a percentage that compares your monthly debt repayments to your pretax monthly income. Lenders calculate your DTI to determine if you can afford to repay another loan. If you are already using the majority of your income on debt payments, it may be difficult to repay a home equity loan.
That’s why most lenders require applicants to have a DTI of less than 43% (and sometimes less than 36%) to qualify for a home equity loan. That means your monthly debt payments must be less than 43% of your total monthly income.
Here’s how to calculate your DTI:
- Add up all of your total monthly debt repayments.
- Divide your monthly debt repayment amount by your pretax monthly income.
- Multiply by 100 to get the percentage.
The debt calculated in your DTI is split between front-end and back-end debt:
- Front-end debt includes your current monthly mortgage payment, property taxes, mortgage insurance and homeowners insurance premiums.
- Back-end debt includes credit card debt, auto loan payments, student loan payments, and any other debts you have.
Home Equity Percentage
The amount of equity you have built up matters – lenders want you to have built up enough equity in your home before you can use it as collateral. Lenders assess rl the loan-to-value ratio (LTV) of your home when approving a home equity loan.
The LTV represents how much you owe on the home compared to its market value. For example, if you have a remaining mortgage balance of $200,000 and the home is appraised for $300,000, your LTV is around 67%. The $100,000 difference between the mortgage balance and the appraised value is the equity you have in the home. .
Don’t expect that you can access the full amount of equity amassed in your home. Typically, most lenders require a combined loan-to-value ratio (CLTV) or home equity combined loan-to-value ratio (HCLTV) of 80% or less; the HCLTV is your primary mortgage balance plus the home equity loan amount compared to the market value of your home. The CLTV is the total amount you’ve borrowed against your home (your primary mortgage, your home equity loan and any other loans that use the home as collateral) compared to the home’s market value. Some lenders may allow a higher LTV/CLTV/HCLTV based on creditworthiness and other factors.
Closing Costs
Most home buyers expect to pay closing costs when purchasing a home and taking out a mortgage, but many are surprised to find out that they’ll also pay closing costs when taking out a second mortgage.
Lenders and other third parties perform much of the same work for your home equity loan as they do for your first mortgage, so the closing costs for both are typically similar. That means you will pay between 2% – 6% of the home equity loan amount in closing costs.
Closing costs are divided between fees for the lender and several third parties. You must pay a mortgage origination fee to your lender to cover the costs of processing and underwriting your loan. Closing costs for the loan also may include: :
- Appraisal fee
- Credit report fee
- Notary fee
- Title search fee
- Insurance fees
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Home Equity Loan Pros And Cons: At A Glance
Let’s review some of the pros and cons of home equity loans:
| Pros | Cons |
|---|---|
| Lower interest rates: Home equity loans typically have lower interest rates compared to personal loans and credit cards. | Risking your home: If you don’t make the required monthly payments, you risk losing your home to foreclosure. |
| Fixed rates: Most home equity loans are fixed-rate loans, so your monthly payments will be the same every month. | Two mortgages: You’ll have two mortgage payments every month: your primary mortgage payment and the home equity loan payment. |
| Lump sum: You receive the entire loan amount as a single, upfront payment. | An extensive application process: : The application and funding process for a home equity loan can take several weeks, so it’s not an ideal financing solution if you need cash fast. |
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Is A Home Equity Loan A Good Idea For You?
Now that you understand the rules surrounding home equity loans, you can better decide if such a loan is right for your situation.
There are several scenarios in which a home equity loan is a great resource. Since you’ll receive a lump-sum payment, this is an excellent solution for large purchases with a fixed price.
Another popular way to use a home equity loan is to finance home renovations. Such renovations often increase the value of your home, so this is a fantastic way to restore the equity you took out of the property to get the loan. Using your loan for home updates and renovations can also provide tax benefits, like the ability to deduct your interest payments on the loan.
A home equity loan isn’t always the best path forward, however. If you don’t have enough equity, can’t afford a second mortgage or need only a small loan, a personal loan may be a better fit. These unsecured loans have higher interest rates but a shorter approval process, allowing you to receive the money you need as soon as possible.
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FAQ
Below are some of the most common questions related to home equity loan requirements:
Additionally, you must have sufficient equity in your home to qualify for a home equity loan. If you have less than 15% – 20% home equity, you should explore other financing options.
The Bottom Line: Home Equity Loan Requirements At A Glance
To qualify for a home equity loan, you typically must show that you have a “fair” credit score, a DTI below 43%, a home equity percentage above 20% and enough cash to pay closing costs.
Ben Shapiro
Ben Shapiro is an award-winning financial analyst with nearly a decade of experience working in corporate finance in big banks, small-to-medium-size businesses, and mortgage finance. His expertise includes strategic application of macroeconomic analysis, financial data analysis, financial forecasting and strategic scenario planning. For the past four years, he has focused on the mortgage industry, applying economics to forecasting and strategic decision-making at Quicken Loans. Ben earned a bachelor’s degree in business with a minor in economics from California State University, Northridge, graduating cum laude and with honors. He also served as an officer in an allied military for five years, responsible for the welfare of 300 soldiers and eight direct reports before age 25.
