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One benefit of homeownership is the ability to tap into your home's equity to access cash without having to refinance your mortgage. A home equity loan or home equity line of credit (HELOC) can give you the cash you need for a major home project or other expenses.
Before you proceed, it's wise to gain an understanding of the lender criteria you'll need to meet to maximize your approval odds. Here are the requirements for a home equity loan or home equity line of credit.
How Do Home Equity Loans and HELOCs Work?
Home equity is the amount of your home you own outright. In other words, it's the difference between your home's current worth and the amount you owe on your mortgage. While there are many ways to build home equity, it typically happens naturally as you make your monthly mortgage payments or when your home value rises.
Both equity products are considered second mortgages—separate from your original one—and require you to secure the loan or line of credit with your home. That means the lender can foreclose on your home if you don't repay the debt for any reason. With your house serving as collateral, the lender's risk is reduced, which could help you qualify for a lower interest rate than other credit products like personal loans and credit cards.
With a home equity loan, you'll receive a lump-sum payment at closing, which you must repay in monthly payments over a term ranging from five to 30 years. For their part, HELOCs work like credit cards, allowing you to draw money as needed, as often as you like, up to your credit limit.
Here are the primary differences between how home equity loans and HELOCs work.
|Home Equity Loans vs. HELOCs|
|Home Equity Loans||HELOCs|
|Disbursement||Lump sum at closing||Borrow when needed, like a credit card|
|Interest rate type||Fixed rate||Typically variable, although some fixed-rate HELOCs are available.|
|Term||Five to 30 years||Consists of a draw period (typically 10 years) and a repayment period (usually 20 years)|
|Repayment||Fixed monthly installments over the specified term||HELOC repayment usually requires interest-only payments during the draw term and principal plus interest payments during the repayment period.|
|Collateral||Secured with home||Secured with home|
Requirements for a Home Equity Loan or HELOC
Consider the pros and cons of home equity loans and HELOCs and how they align with your needs to help you determine if either is a good fit for you. In either case, you'll need to meet specific criteria to qualify, and those requirements can vary from one lender to the next. Here are the typical requirements for home equity loans and HELOCs.
1. Sufficient Equity in Your Home
Generally, lenders require a minimum of 15% to 20% equity in your home. Equity is the amount of your home you own outright. So, if your home value is $500,000 and you owe $400,000 on the mortgage, you have $100,000, or 20%, in home equity.
2. Good Credit
While minimum credit score requirements vary by lender, most look for a FICO® Score☉ of at least 680. Some lenders require a minimum credit score of 720, but the higher your score, the better. Other lenders may approve your home equity loan or HELOC with a credit score below 680 if you have substantial equity or income.
3. Solid Payment History
While your payment history is a factor in your credit score, lenders still want to review your credit report to see how well you manage your debt. Specifically, lenders want to see that you make consistent, on-time payments on all your credit accounts.
Your lender could consider it a risk to extend a loan or line of credit if they see a record of late payments. This concern is especially true with second mortgages like home equity loans and HELOCs, where the lender would be second to recoup their loss if your home ever faces foreclosure.
4. Proof of Income
As with most loans, lenders want to verify you have sufficient income to repay a home equity loan or line of credit. They also use your income and other factors to determine your borrowing limit. Before you apply, make sure you have pay stubs, W-2s, tax returns or other types of income verification on hand to prove you have adequate income.
5. Low Debt-To-Income Ratio
Your debt-to-income ratio (DTI) is one of the most important considerations lenders review before making an approval decision. Your DTI measures the amount of your monthly gross income that goes toward your monthly debt obligations. In general, a lower DTI indicates to lenders you're more likely to successfully manage a new loan or credit line than a borrower with a high DTI. Lenders typically prefer a DTI of 43% or less.
6. Proof of Homeowners Insurance
Lenders don't typically approve a loan secured by your home unless you have homeowners insurance. The insurance protects the lender's investment against a financial loss if your home suffers a catastrophic event.
Alternatives to Home Equity Loans and HELOCs
Home equity loans and HELOCs can be valuable tools to tap into your home equity to consolidate debt or pay for large expenses. Still, other financing options may align better with your specific situation. Here are some alternatives to consider:
- Cash-out refinance: With a cash-out refinance, you replace your existing mortgage loan with a new, larger one, preferably with a lower interest rate. The new mortgage pays off the old one, and you receive the difference as a lump sum at closing. Cash-out refinances have declined in popularity in recent years amid high mortgage rates.
- Personal loan: Unlike a home equity loan or HELOC, a personal loan is an unsecured debt. That means you don't have to offer your home as collateral to secure the loan. However, the lack of collateral increases the lender's risk, so you'll likely pay higher interest rates than you would with a home equity loan or HELOC. The average interest rate for a 24-month personal loan is 12.17%, according to recent data from the Federal Reserve. Loan amounts range from a few thousand dollars to $100,000, with repayment terms usually spanning two to five years.
- Personal line of credit: Many banks and credit unions offer personal lines of credit, revolving credit that works much like a credit card. You can borrow money as needed up to your borrowing limit and only pay interest on the amount you borrow. However, you don't need to put up your home as collateral for the line of credit. Typically, you receive bank checks or a bank card to make purchases or withdrawals.
- Balance transfer credit card: If your primary goal is to consolidate high-interest debt, a balance transfer credit card may be your best option to combine all your debt into one account. This is especially true if you can repay the debt during the card's introductory 0% APR period, which can last as long as 21 months. However, any remaining balance left over once the introductory period expires will likely incur the card's standard credit card APR, which can be significantly high.
Generally, most lenders allow you to borrow around 60% to 85% of your home's equity with a home equity loan or line of credit. You can calculate your home equity by subtracting your remaining loan balance from your home's value. So, if your home is worth $400,000 and your loan balance is $300,000, you have $100,000 in home equity. Depending on your creditworthiness and other factors, you may qualify to borrow 60% to 85% of that amount, or $60,000 to $85,000. Of course, you can borrow a smaller amount; most banks require a minimum borrowing amount of $10,000.
You don't always need a job to get a home equity loan or HELOC, but you do need regular income. For example, your income may come from a pension or another retirement account, your spouse's job, alimony, government assistance or another source.
Lenders typically require an appraisal to verify the valuation of your property before they can approve your home equity loan or HELOC. Since your home serves as collateral, the lender must confirm whether you have sufficient equity to secure the loan. The appraisal also helps your lender determine the amount you can borrow based on your equity.
Shore Up Your Credit Before Applying
Home equity loans or home equity lines of credit are two options that may help you tap into your home's equity for cash. You may boost your odds of approval by ensuring you meet common requirements, such as having 15% to 20% equity in your home, a DTI ratio below 43%, a solid payment history and verifiable proof of income and homeowners insurance.
Of course, your credit plays a significant role in your chances of approval and the interest rate you receive. You may qualify with a credit score of at least 680, but you may improve your terms with a higher score.
If your credit score is lower than you'd like, consider getting your credit report and credit score for free from Experian. You'll discover where your credit stands and any potential issues that may be harming your score.