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This article first appeared on the Credible blog.
If you’re looking to renovate your house, cover sudden expenses, or pay for your child’s college tuition, your home equity may be able to help.
With a home equity loan or home equity line of credit (HELOC), you can turn that equity into cash, using it to lighten your financial load or improve your property, among other things.
What’s the difference between a home equity loan and HELOC?
Home equity loans and home equity lines of credit both let you borrow against the equity in your home. However, the loans are structured differently, so they’re not interchangeable.
A home equity loan is typically a fixed-rate loan. It works much like a personal loan in that you receive your funds as a lump sum and repay the loan in monthly installments, usually over a period of five to 30 years.
A HELOC, on the other hand, is a revolving line of credit secured by your home. During the loan’s “draw period” (or borrow period), you can draw from the line of credit as needed up to your credit limit — similar to a credit card. Most HELOCs have a draw period of 10 years.
Once the HELOC’s draw period ends, you’ll either need to pay the balance in full or over a fixed period, known as the “repayment period.” Repayment periods can last up to 20 years. Unlike home equity loans, HELOCs typically have variable interest rates, so your payments may go up or down over time.
Benefits of a home equity loan
A home equity loan has some unique benefits that make it a good option for some homeowners, including:
- Predictable payments: A fixed rate means predictable payments over the entire term of the loan.
- Lump sum: The funds are paid to you all at once, making it easy to cover a one-time expense like a major home repair or the down payment for the purchase of a second home.
- Tax-deductible interest: The interest may be tax-deductible if you use the loan to buy, build, or improve your home.
Benefits of a HELOC
A HELOC has unique benefits of its own, some of which a home equity loan doesn’t offer:
- Flexible withdrawals: You can draw whatever amount you need, as you need it. This makes it a good choice for ongoing expenses like home remodeling or college tuition.
- Interest-only payments: Some HELOCs allow you to only make interest payments on the amount that you borrow during the draw period. Just keep in mind that you’ll still need to pay the rest of the balance off once the repayment period begins.
- Available in advance: You can take out a HELOC years before you need it, without having to make payments (unless you use the money, of course). This can be useful if a financial emergency — such as you losing your job — were to occur.
Requirements for tapping your home equity
- At least 15% equity in your home
- Debt-to-income ratio of around 43% or less
- Credit score in the mid-600s — or higher
- History of paying your bills on time
- Income verification
At least 15% equity in your home
When it comes to home equity loans and HELOCs, many lenders require you to have 15% equity in your home, though some may go higher. Wells Fargo, for example, requires at least 20%.
You won’t be able to tap all that equity, though — no matter how much you have. Your lender will set your borrowing limit based on your loan-to-value ratio (how much you still owe on the home versus its market value.) Your LTV is basically the inverse of your equity, so the more equity you have, the lower your LTV will be.
Generally, lenders want to see a combined LTV of no more than 85%. To calculate your LTV — as well as your equity stake, you’ll first need your property value. You may need a home appraisal for this, which typically costs around $400.
Once you know your home’s value, divide your loan balance by the value and multiply by 100. This is your LTV.
For your equity, you’ll subtract the loan balance from your home’s value, and then divide that number by the home’s value.
Here’s an example:
- Loan balance: $125,000
- Home value: $275,000
- LTV: 45.45% (125,000 / 275,000 x 100)
- Equity: 54.54% (275,000 – 125,000 / 275,000)
Why it matters: Lenders use your equity and LTV to determine how much you can borrow and comfortably afford.
In the above example, with a home value of $275,000 and a maximum LTV of 85%, your two loans would need to total $233,750 or less (275,000 x 0.85) for you to qualify.
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A debt-to-income ratio of around 43% or less
Your debt-to-income ratio (DTI) — or what percentage of your monthly income your debts take up — will also play a role. Typically, lenders require a DTI of 43% or lower.
To calculate your DTI, add up your monthly expenses, including your mortgage payment, student loan payments, regular bills, child support, and other debt, and then divide that by your monthly income.
Here’s an example:
- Monthly debts/obligations: $1,800
- Monthly income: $4,000
- DTI: 45% (1,800 / 4,000)
Home equity loans offer less flexibility regarding DTI than HELOCs. In most cases, home equity loan borrowers must have a 43% DTI or lower to qualify. Some lenders are even more stringent, requiring DTIs as low as 36%.
With HELOCs, lenders have more leeway. They may go as high as a 50% DTI in some cases.
Why it matters: Lenders use your DTI to make sure you have the available funds to continue meeting your monthly obligations, as well as cover your new loan payment.
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A credit score in the mid-600s — or higher
Exact credit score requirements vary by lender, but you generally need a score in the mid-to-high 600s to qualify for a home equity loan or HELOC. A high score (think 760 or above) typically makes for the easiest qualification process and gives you access to the lowest interest rates.
If your score is in the low 600s or below, you may have trouble securing a home equity product, though it’s not impossible. If you’re less risky in other areas — you have a low LTV or DTI, for example — then you may still be able to qualify. Just be sure to shop around and consider a number of lenders if you fall into this low-score category.
Why it matters: Your credit score reflects your payment habits. The higher the score, the easier it will be to get a home equity loan and the better rate you’ll get.
A history of paying your bills on time
Lenders will also pull your credit report and evaluate your payment history. They want to see that you’re paying your bills consistently and on time (this indicates that you’ll likely do the same on your home equity loan).
A history of spotty or late payments is a big red flag to a lender, even if your score is fairly high. Because of this, it’s important to stay on top of your bills — especially in the months leading up to your loan application.
Why it matters: Being consistently late on your payments indicates you’re an unreliable and high-risk borrower. It may mean not qualifying for a home equity loan or, at the very least, getting a high interest rate.
Employment and income verification
Your loan application will ask you to enter your income. The lender will then ask you for documentation — including bank statements — to verify that amount. The specific documentation you need depends on the source(s) of your income.
Common sources of income include:
- Employee wages: The lender will want to see your most recent W-2 and pay stubs.
- Self-employment: You’ll document self-employment income with your most recent federal tax returns, including Schedule C, Profit or Loss from Business.
- Social Security or Social Security Disability Income: You can print a benefit verification letter from your my Social Security account.
- Pension and government annuity: Benefit statements, retirement award letters, and 1099 forms can all be used to document income from pensions and government annuities.
Why it matters: Lenders verify employment and income to make sure you can afford your loan payments now and won’t default on the loan in the future.
Want another way to leverage your home equity?
If you’re not sure you qualify for a home equity loan or HELOC — or are afraid your interest rate would be too high — a cash-out refinance is another option to explore. These have slightly less stringent requirements and generally come with lower interest rates than home equity loans or HELOCs, especially in the current market.
Another advantage is that a mortgage refinance replaces your existing loan, so you’ll only make one monthly payment — and potentially lower your interest rate in the process.
If you’re considering a cash-out refinance, be sure to look at as many lenders as possible. Credible makes finding the best deal easy — you can see prequalified rates from our partner lenders in as little as three minutes.
About the author: Aly J. Yale is a mortgage and real estate authority. Her work has appeared in Forbes, Fox Business, The Motley Fool, Bankrate, The Balance, and more.