A home equity loan is a great way to cover a big expense at a lower interest rate than with a personal loan or credit card. Lenders determine your eligibility based on your home’s equity, your credit score, debt-to-income ratio, and more.
What Is a Home Equity Loan?
A home equity loan uses your home as collateral, and you pay the loan back in fixed monthly payments. The amount you’re able to take out depends on your credit history, income, and your home’s current market value.
Pros of a home equity loan
- Interest payments may be tax-deductible if you use money for home improvements
- Fixed interest rates and consistent monthly payments
- Easy to predict and budget for
- Can be used for debt consolidation
- More affordable than private loans
Cons of home equity loans
- Puts your home at risk as collateral
- May not net as much if you sell your home because you still have to pay the balance of the loan
- Interest rate and total payment will be higher with bad credit
- Long-term, fixed-rate debt payment
- Two mortgages instead of one
Home equity loan vs. HELOC?
Unlike a home equity loan, where you withdraw a lump sum, a home equity line of credit (HELOC) acts more like a credit card. You only withdraw the money you need and only pay interest on the amount drawn. Learn the pros and cons of each type of loan.
Do I Qualify For a Home Equity Loan?
Many factors help determine whether you’re eligible for a home equity loan, though the three basic requirements include:
- At least 20% equity in your home OR a loan-to-value ratio under 80%
- A score of at least 620 (if your score is lower, it’ll be harder to qualify)
- A debt-to-income ratio below 43%
Note: These numbers aren’t set in stone. Each plays a different role in deciding your loan’s terms, interest rate, and eligibility. Read on to learn more, plus find additional ways you can improve your chances of qualifying.
1. Home Equity and Loan-to-Value Ratio
To qualify for a home equity loan, lenders first look at two things: how much equity you have in your home and your loan-to-value (LTV) ratio.
Banks typically let you borrow up to 80% of your home’s equity
Your home’s equity is how much your home is worth minus how much you still owe on your mortgage. To calculate your maximum home equity loan, you multiply your equity by .80.
For example, let’s say your home is worth $200,000 and you owe $75,000 on your mortgage. That means you have $125,000 in equity. You could qualify for a home equity loan of up to $100,000. ($125,000 x .80 = $100,000)
Experts recommend an LTV ratio under 80%
The LTV ratio is the amount you want to borrow divided by your home’s total worth. You should still have at least 20% equity in your home after taking out a home equity loan. If your home equity loan has an LTV higher than 80%, you’ll have to buy private mortgage insurance, and you may pay higher mortgage interest rates.Using the example above, if your home is worth $200,000 and you wanted to borrow $100,000, your LTV ratio would be 50%.
2. Credit Score
Most home equity lenders look for a FICO credit score of 620 or higher, though at least 740 is ideal. The better your credit score, the lower your interest rate-and the lower your monthly payments.
The chart below outlines the differences in interest rates and monthly payments based on your credit score for a 15-year, $50,000 home equity loan.
|FICO credit score||Interest rate||Monthly payment|
Note: Table is based on national interest rates on June 25, 2020.1
In this scenario, a very good credit score would save you $171 on monthly payments compared to a poor credit score. Over the course of the loan, that’s $30,780 total.
What if I have bad credit?
It can be tough to get any type of loan when you have bad credit. A low credit score doesn’t mean you can’t qualify for a home equity loan, but it will affect the terms of your loan. Learn more about getting a home equity loan with bad credit.
3. Debt-to-Income Ratio
To qualify for a home equity loan, you’ll have to show lenders that you can handle your current debt in addition to the home equity loan. Your debt-to-income ratio, or DTI, is what you owe (your debt) divided by what you make (your income). Lenders typically look for a DTI in the low 40s or less, but some will go as high as 50%.
A higher DTI is a turnoff for lenders because it means you have less to put toward a potential home equity loan. Ultimately, it’s a balancing act between your credit score and your DTI, but if you have a lower credit score, it’s helpful to have a lower DTI.
What’s my DTI?
To determine your potential DTI, we combine all your monthly debt payments, including estimated home equity loan payments. Then, we divide the sum by your gross monthly income. To get your DTI as a percentage, we multiply the result by 100.
Improve Your Eligibility
There are a few other factors that could potentially improve your eligibility for a home equity loan. These can be helpful if your DTI is a bit high or your credit score is a bit low.
Proof of income
Lenders will evaluate your income to make sure you can pay back the loan. The more money you make, the more it can improve your DTI.
Healthy credit history
Your lender will look at more than today’s credit score. If you carry a considerable amount of debt, your loan may be denied, no matter your current number. A lender might also look favorably on your application if your history shows a steady increase as you rebuild from a less-than-perfect score.
On-time bill pay
A solid record of paying bills on time will show your lender that you’re reliable, improving your odds of approval.