How to qualify for a home equity loan
A home equity loan is a type of secured loan that allows you to borrow a portion of your home equity as cash using your home as collateral for the loan. These can be an effective tool that homeowners can use to finance home improvements, consolidate high-interest debts, or pay for other large expenses. However, having equity isn’t the only qualification requirement for someone interested in a home equity loan.
Since your home secures the loan, you could potentially risk foreclosure if you fail to pay it back. Because of the high stakes involved, lenders often have strict qualification requirements for home equity loans. These may include requirements regarding factors such as your credit score, credit history, and debt-to-income (DTI) ratio.
Home equity loan qualification requirements
Qualifying for a home equity loan requires you to meet minimum equity, credit, and income standards, among other requirements. While specific requirements vary from lender to lender, there are several items that you can typically expect to see when looking to apply:
- To qualify for a home equity loan, you need to meet home equity, credit score, income, debt-to-income (DTI) ratio, and loan-to-value (LTV) ratio requirements.
- Home equity loan requirements vary from lender to lender, so shopping with different lenders can help you find the best loan for your needs.
- Even if you don’t meet requirements right now, you can take steps to improve your chances for a loan approval.
How does a home equity loan work?
A home equity loan is a type of second mortgage, and it works similarly to the primary mortgage on your home. When taking out a home equity loan, you use a portion of the equity you have built up in your home as collateral in exchange for a loan. Much like a mortgage, you make monthly payments for a predetermined amount of time, typically for a term of between 5-30 years.
Most home equity loans come with fixed rates, as opposed to variable rates. This means you can count on a predictable monthly payment that isn’t subject to fluctuations in interest rates. Once you get approved for a home equity loan, your fixed rate is “locked” — meaning it won’t change even if rates move higher. To get an idea of what your monthly payments might be, you can check current home equity loan rates and use a monthly payment calculator to help estimate.
What do you need to qualify for a home equity loan?
Although the specifics may vary, most lenders look at the following five factors to determine your eligibility for a home equity loan. Thresholds for each of these categories depend on which lender you’re looking at, and some lenders may account for additional factors. This list includes some of the most common requirements you can expect:
- Credit score: When applying for most types of financing, the lender will pull your credit score. Generally, those with higher credit scores are given the best interest rates. This means homeowners with better credit scores may wind up paying less in interest charges over the life of their loan.
- Income: Another important factor that lenders look at is your income. Typically, lenders prefer to see that a borrower has a steady source of income for a number of years. To evaluate your income, lenders may ask you for your most recent W-2 forms and paystubs. For those who are self-employed, lenders may ask for one (or several) years of tax returns showing your self-employed income. Lastly, for those who are retired, lenders typically look for proof of retirement income, whether that be a 401(k)-distribution letter or some other type of retirement award letter.
- Payment history: Your lender will likely also pull your credit report where they will see your payment history. If you have missed a payment on one of your debts in the past, that missed payment may be reported to credit bureaus who will include a record of it on your credit report. Before a lender checks your credit report, get a free copy of your credit report to ensure it is up-to-date and there are no errors.
- Debt-to income ratio: Lenders also look at your debt-to-income (DTI) ratio when you apply for a home equity loan. Your debt-to-income ratio is calculated by adding up all your monthly debt obligations — including your potential payment on the new home equity loan — and dividing that number by your total monthly income. While DTI requirements vary from lender to lender, it is common to see them require a DTI of 43% or less. Be sure to talk with your lender about their DTI requirements before applying.
- Available home equity: You will need a minimum amount of equity in your home. Lenders calculate this using your combined loan-to-value ratio (CLTV). CLTV is calculated like this: CLTV = (Loan Amount + Mortgage Balance) / Home Value. Though you may find many lenders that will let you borrow up to 80% CLTV, some will let you go up to 90%, so make sure to shop around for the options that work best for you.
What disqualifies you from getting a home equity loan?
Unfortunately, there are several reasons why you might be ineligible for a home equity loan — one of the most prominent issues is missing the minimum LTV or DTI requirements.
It’s possible that someone looking to borrow either doesn’t have enough equity in their home (meaning their LTV ratio is too high), or they have other loans on their credit report that have inflated their DTI. Depending on which situation applies, lenders cannot issue them a home equity loan until they either earn additional equity in their home or pay off some of their existing debts.
Another common issue you might run into is having a credit score or payment history not meeting a lender’s requirement. Many lenders have minimum credit score requirements and require a consistent history of on time payments with existing loans. While building credit may take a little time and upfront work, you can improve your credit score by taking actions such as paying off credit card balances or increasing your total line of credit.
How to improve your home equity loan application
To make sure you have the best chance of being approved for a home equity loan, you should work to make sure that you have a credit score of at least 620 or higher.
Be sure that all the information on your credit report is correct and up to date. If you find any inconsistencies or errors on your credit report, be sure to file a dispute as soon as possible so the issue can be resolved.
Additionally, you may want to speak to multiple lenders to get an idea of what their requirements are for home equity lending. Calling the home lending department of a bank or other lender is easy, and doing so only takes a few minutes. Reaching out to lenders sooner rather than later is key, as it may take some time to do things like accrue equity in your home or pay down some of your existing debts.
The earlier you reach out to a lender, the more time you have to work on any areas that may present a problem during the application process.
How to improve your credit score
Your credit score is typically an algorithm that is generally comprised of five facets of your credit past:
- Payment History (35%)
- Amount Owed (30%)
- Length of Credit History (15%)
- Types of Credit Used (10%)
- Recent Inquiries / Accounts Opened (10%).
Considering those contributing factors, there are a few steps you can take that may help improve your score:
- Make regular payments on time for your open accounts consistently. Your credit score may start to improve when you don’t have any late or missed payments.
- Pay down your debts to lower the amount owed. By paying more than the minimum payment and limiting any new spending on your credit accounts, you can drive this factor down to help push your credit score up. As you pay down debt, don’t close any credit card accounts with zero balances. You can keep the average age of your accounts higher by leaving them open and using them to make small purchases infrequently.
- Limit any new applications for credit or loans until you feel your credit score is sufficient to earn approval. The number of hard inquiries on your credit report may push your score down and typically continue to have an impact on your score for up to two years.
How to improve your income qualifications
As your ability to repay is a prime consideration in your loan application, anything you can do to increase your income can help — whether through a promotion, raise, new job, or second job. Keep in mind that with any change, you may need to provide evidence of a steady income at any new level for a period of 30 days or more.
Take a look at our application checklist to see the types of documentation typically needed during the application process. This may give you an idea of what a lender wants to see so they can verify your income. Collect and review these documents before applying to make sure they accurately reflect your sources of income.
An increased income, decreased debt load, or both together will lower your DTI and may increase your likelihood of earning offers for lower rates or more flexible terms.
How to improve your credit history
Late payments can stay on your credit report for up to seven years. However, more recent delinquencies may impact your score more than older ones.
While healthy credit habits such as limiting spending and making monthly payments on-time will likely contribute to a better overall financial profile, be sure to review your credit report before applying for a loan to catch any potential inaccuracies or errors.
You may also be able to work with your creditors to update the status of your accounts or potentially remediate any negative reports from the past.
How to improve your available home equity
Your home’s equity measures your current home’s value and subtracts the amount remaining on your mortgage loan. To increase your equity, you need to either increase the assessed value of your home or decrease the amount remaining on your mortgage.
When assessing the current value of your property, a lender will likely require some form of appraisal. This could be through an automated valuation model (AVM), property condition report, or a walkthrough appraisal. A lender may also ask to review your mortgage statements.
Increasing your home’s value doesn’t require a loan. You can put some sweat equity into your house by renovating kitchens and bathrooms or improving the curb appeal by making some landscaping or simple DIY exterior improvements.
While each month of mortgage payments helps improve your available equity, putting more than the minimum towards your monthly mortgage bills can amplify the impact.
Should you get a home equity loan?
Whenever you are considering borrowing money, it’s always best to talk with a trusted financial advisor and consider all the options that are available to you. The best lending product for you depends heavily on your own personal circumstances.
For instance, if you want to tap into your home’s equity to cover expenses you’ll be able to pay off in the near future, you may want to consider a home equity line of credit (HELOC). A HELOC acts more like a credit card than a traditional loan, meaning you can borrow as much or as little money as you need, up to your approved line of credit limit.
If you’re looking to tap into your home’s equity and pay it off over the course of 30 years and interest rates are lower than the rate you got on your primary mortgage, a cash out refinance may be a better option for you. This is because you may be able to pull equity out of your home and lower your interest rate at the same time.
Homeowners that want to look at an unsecured loan to avoid tapping into home equity can consider a personal loan or credit card. While rates for both options aren’t as favorable as those found on home equity loans, HELOCs, and refinances, personal loans and credit cards typically provide you with quicker access to cash.
Closing thoughts: Home equity loan requirements
Meeting the requirements for a home equity loan can be a complex process, but it is necessary if you want to access the equity in your home to cover large expenses, make home improvements, or consolidate high interest debts.