Home equity loan requirements | CNN Underscored Money

Home values rose dramatically during the COVID-19 pandemic, which translated to increased home equity. In fact, in mid-2023, homeowners collectively held more than $31 billion in home equity, according to the Federal Reserve Bank of St. Louis. Home equity loans allow you to leverage the equity you’ve built in your home and borrow at more affordable rates than you could get on a personal loan or credit card.

When determining your creditworthiness, home equity lenders typically assess your credit scores, the amount of equity you have in your home and how much debt you have. Eligibility requirements for a home equity loan tend to be more stringent than on a regular mortgage because the lender takes on additional risk. But if you qualify, your home’s equity can be a powerful financial resource that helps you meet your long-term goals.

4 common home equity loan requirements

Eligibility requirements for home equity loans vary by lender. However, here are some common requirements you’ll likely encounter.

At least 15% equity remaining after closing your home equity loan

The amount of equity you have in your home determines your loan-to-value (LTV) ratio, or your amount owed versus how much the property is worth. Most lenders require an LTV ratio of 85% or less, although some allow you to borrow only 80% of what your home is worth. Some lenders may allow you to borrow up to 90% of your home’s value, but tapping so much equity puts you at risk of owing more than your home is worth — also known as being underwater on your mortgage.

The total amount of debt secured by your home — including your mortgage, your home equity loan and other liens — can’t exceed 85% of your home’s value.

Good to know: Your LTV ratio is the inverse of your equity. For example, if you have 15% equity, that means your LTV ratio is 85% (15% + 85% = 100%).

Example: Let’s say your home is valued at $500,000. Your current mortgage balance is $350,000. Your preferred lender allows an 85% loan-to-value ratio, so the most you can borrow is $75,000.

The more equity you have, the more you can borrow using a home equity loan.

Credit scores of 620 or better

As with any form of borrowing, the higher your credit scores, the more likely you are to qualify for financing and receive competitive rates and terms.

“Typically, a borrower would need a 700 or higher credit score, although there are programs that will allow for scores as low as 620,” said Shmuel Shayowitz, president and chief lending officer at Approved Funding, national mortgage lender. A lender’s lowest rates are often reserved for borrowers with scores over 750.

If your credit scores are too low, it can be worthwhile to work on improving them by paying down some of your debt and making on-time payments. You might also consider applying with a creditworthy cosigner.

Debt-to-income ratio of 36% or lower

Lenders also assess your debt relative to your income to ensure you only borrow what you can afford to repay.

Example: Let’s say you earn $6,000 a month before taxes. Between your mortgage, credit cards and student loans, you pay a total of $2,100 toward debts each month. Your debt-to-income (DTI) ratio would be 35% ($2,100 / $6,000 = 0.35).

Typically, your total debt (including your new home equity loan) should account for no more than 36% of your pre-tax income. Some lenders may allow a DTI as high as 43%, but a low DTI may result in lower rates on your home equity loan.

Income and payment history

Lenders want to see that you have an established history of paying your bills on time, plus a stable income. You may need to verify two years of income history via pay stubs, tax returns or W-2s, and your lender will likely want to confirm that you’re currently employed before moving forward with the loan.

Your lender will also pull your credit reports to review your payment history. If your reports show a pattern of late or missed payments, your lender may decline your application or require additional documentation.

What is a home equity loan?

Equity is the difference between the appraised value of a property and the outstanding loan balance. For example, if your home is worth $500,000 and your mortgage balance is $350,000, you have $150,000 in equity (or 30%).

A home equity loan allows you to borrow against this equity to receive a lump sum of cash. These loans have fixed interest rates, and you’ll repay the funds over a set repayment term, commonly five to 30 years. You can use home equity loan funds for nearly any purpose, including home improvement or debt consolidation.

Like your mortgage, a home equity loan is secured by your property. When you borrow a home equity loan (sometimes called a “second mortgage”), your lender will appear as an additional lienholder on the title.

Home equity loans can be a relatively inexpensive way to borrow money, as compared to personal loans or credit cards. Still, there is risk involved — if you can’t repay the loan, you could lose your home to foreclosure.

What to know about home equity loan rates

Home equity loans have fixed interest rates, which means your rate won’t change over time. Rates are typically lower than those on unsecured debt like personal loans, but higher than the rates on a first mortgage.

“Data from recent securitizations shows that home equity loan rates for some lenders are about two to three percentage points higher than mortgage rates,” according to Kelly Miskunas, senior director of capital markets at Better, an online mortgage lender.

There’s a good reason why their rates tend to be higher — home equity loans pose a higher risk for lenders than mortgage loans.

“This heightened risk stems from the fact that, in the event of a foreclosure sale, the home equity loan lender can only recover their funds after the primary or senior mortgage holder has been fully repaid,” said Dan Green, CEO at HomeBuyer.com.

If you want the best possible rate, ensure that your credit scores are in tip-top shape and compare quotes from multiple lenders.

How to get a home equity loan

The process for applying for a home equity loan varies by lender, but generally, you’ll take the following steps:

1. Determine how much equity you have. Start by having your home professionally appraised — your lender is likely to require this step anyway. Once you know your home’s value, subtract your current mortgage balance to understand how much equity you have in your home.
2. Check your credit scores. The higher your scores, the more likely you are to qualify and receive competitive rates. Your bank or credit union may offer free access to your scores, or you can pay a third-party service.
3. Calculate your DTI. Since lenders will want to see a low debt-to-income ratio, it’s smart to know how your income compares to your debt before applying. If your DTI is too high, focus on paying down other debts before applying for a home equity loan.
4. Compare loan offers. As with any consumer loan, the best way to get a low rate is to compare offers from multiple lenders. Get pre-qualified with various lenders and then review the offers you receive to find the loan with the lowest rate and fees. In addition to comparing the loans’ APRs, also review origination fees, closing costs and prepayment penalties.
5. Submit an application. Once you’ve found the right loan for your needs, submit a formal application. You’ll have to agree to a hard credit pull, which can temporarily ding your scores by about five points. Your lender will request documents to verify your identity, residence and income, and if you’re applying with a cosigner, they’ll need to submit the same documentation.
6. Underwriting and closing. After submitting your completed application, the lender will work through verifying your information and assessing your creditworthiness. The entire process can take up to six weeks to complete, though some lenders may be able to provide funds within one or two weeks.

Home equity loan alternatives

Even if you believe that a home equity loan can help you meet your financial goals, it’s wise to consider the alternatives before committing.

HELOC

Best for: Borrowers who aren’t sure how much money they’ll need

A home equity line of credit (HELOC) also allows you to borrow against the equity in your home. Interest rates and eligibility requirements tend to be similar to those on a home equity loan — but rather than receiving a lump sum, a HELOC is a line of credit you can draw from as needed, like a credit card. And you only pay interest on the amount you borrow. Interest rates are usually variable and adjust with the market, so your monthly payment will likely fluctuate.

Cash-out refinance

Best for: Borrowers who want to refinance their primary home loan

A cash-out refinance involves taking out a new loan to replace your current mortgage and borrowing more than you owe to pocket the difference. For example, if you owe $100,000 on your home loan and need an additional $50,000 in equity out of the home, you could get a $150,000 cash-out refinance loan. The cash can be used for any legal purpose (though it’s wise to only borrow for certain purposes, like home improvement or debt consolidation), and you’ll repay those funds as part of your mortgage payment.

Since recent mortgage rates are higher than they’ve been in 20 years, a cash-out refinance may not make sense for most borrowers since it could mean forfeiting a low APR. You’ll also have to account for upfront closing costs, which can be 2% to 6% of your loan amount. (Be aware that so-called no-closing-cost refinance lenders usually roll these charges into your loan balance or hit you with a higher rate.)

Personal loan

Best for: Borrowers with excellent credit (or a creditworthy cosigner) who don’t want to put their home at risk

A personal loan is an unsecured loan, so your eligibility is determined by the strength of your credit history (or your cosigner’s). You borrow a lump sum at a fixed rate and pay it back on a set schedule, commonly two to seven years.

There are also secured personal loans in case you don’t have good credit or a cosigner — but you do have savings or other assets. A secured loan uses those assets as collateral in case your repayment goes awry, but at least you wouldn’t have to put your home’s title on the line.

While you may have to pay a higher rate than with a home equity loan, you don’t need equity in your home to qualify for a personal loan and you won’t be putting your home at risk.