How to qualify for a home equity loan
A home equity loan accesses your home’s growing value, and since they’re seen as less risky for lenders, you can get better rates and terms. Home equity loan requirements are the following: you must have accumulated equity in your home, have good or decent credit, demonstrate your ability to repay, and a low debt-to-income ratio.
1. Accumulate Home Equity
To determine how much equity you’ve built up in your home, subtract the amount remaining on your mortgage from the total value of the property. This is more commonly described as a loan-to-value ratio (LTV ratio)—or, the remaining balance on your loan compared to the value of your property.
Generally speaking, lenders require at least an 80% LTV ratio remaining after the home equity loan. This means they require you to own at least 20% of your home in order to qualify. Depending on your financial track record, lenders may allow you to borrow up to 85% of your home equity.
Keep in mind that these types of loans aren’t particularly useful for borrowing small amounts of money. Generally, lenders won’t offer loans under $10,000, and even that is quite low, as the amount is usually more in the $25,000-$100,000 range. If your needs can be met with a smaller amount, perhaps a home equity line of credit (HELOC) might be more convenient.
2. Raise your Credit Score
Good credit is a definite advantage when applying for a home equity loan, and can save you thousands of dollars over the life of your loan. Though these loans are secured by collateral, and lenders can afford to be more lenient in their requirements, a score of less than 620 can present considerable difficulties.
Most lenders use FICO scores from all three of the credit bureaus—Experian, TransUnion and Equifax— to determine your credit score. Each of the bureaus generates a credit report based on the information about you that they have on file. Even if you think your credit score seems accurate, it’s worth it to address any possible errors before initiating the loan application process. This is even more true if your score is low, in which case you might need to raise it before even attempting to apply.
3. Demonstrate ability to repay
Home equity lenders will look at your work history, income, and other monthly financial obligations to decide whether you can afford to repay the loan. Generally, this means a consistent employment history—preferably with the same employer or in the same industry for at least two years— verifiable income, and W-2 forms for the past two years.
If you are self-employed, or earn more than 25 percent of your income through commissions, lenders will also require two years of tax returns. Earning a sufficient income is only part of proving your ability to repay, however.
4. Lower your debt-to-income ratio
Your debt-to-income ratio is calculated by dividing your monthly debt payments by your monthly income. A good number is below 36 percent, but generally speaking, the highest a borrower can have is around 45 percent. If yours is high, try to cut down on unnecessary expenses, so your lender will see more earnings left over every month.
By and large, the monthly debt payments that are added up include your house payment (principal, interest, and taxes), homeowner’s insurance, direct liens if any, home association dues, credit card bills, IRS payments and even student loans that may not yet be in the process of repayment. If much of your income is dedicated to paying off existing debts, it follows that your ability to pay off new debt is substantially less than if you have a large percentage of earnings left over every month.
5. Verify if there are other costs and fees
The approval process for a home equity loan is almost always less strenuous than a mortgage approval process. Besides the factors listed above, lenders also require an appraisal of your home. There are some other closing costs for home equity loans, however, and it’s a good idea to comparison-shop different companies’ fees.
These additional costs and fees can include:
- Attorney or title company representative fees
- Title search
- Document preparation costs
- Application fee
- Appraisal fee
- Some also have a maintenance fee
Some companies also offer the option of paying points in order to lower the interest rate of your home equity loan. One point is equal to one percent of your loan amount, so for a $200,000 loan, a point would be $2,000. Comparing lenders and asking them to reduce or waive some of these fees can save you hundreds or thousands of dollars. A good place to start that search is our list of the top ten home equity lenders of the year.