Requirements for a HELOC or Home Equity Loan (2024)
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Summary:
A home equity loan or home equity line of credit (HELOC) are two great ways to leverage your home’s equity for a multitude of purposes, such as making home improvements, consolidating high-interest debt, or paying for education expenses. But you’ll need to meet some minimum requirements to gain loan approval such as having a good credit score, sufficient income, and enough equity in your home to satisfy most lenders.
If you’ve spent years building equity in your home and find that you have a project (or projects) you want to finance, or perhaps want to purchase an investment property, you may be wondering how to best leverage that equity. And what are the requirements you need to meet to qualify for home equity financing?
Read on to learn about the requirements for a HELOC or home equity loan, what you need to know before you apply, and which type of loan is right for you. First, let’s do a quick recap of the difference between a home equity line of credit (HELOC) and a home equity loan.
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Home equity loans vs. HELOCs
HELOCs and home equity loans are two ways to borrow against your home’s equity (the difference between what your home is worth and your current loan balance). For example, if your home’s market value is $500,000 and your mortgage balance is $200,000, then you have $300,000 in equity.
Home equity loan
A home equity loan is a loan that uses your house as collateral and provides the borrower with a lump sum of money. You will have a set repayment period with a fixed interest rate that’s typically much lower compared to other lending products like a personal loan. It’s considered a second mortgage on the home, meaning it has its own separate set of monthly debt payments which are always the same.
HELOC
A home equity line of credit (HELOC) also lets you borrow money using the home as collateral. But a HELOC works more like a credit card in that you’re given a revolving credit line up to a set amount — your credit limit. You can draw on this line of credit as much or as little as you need during the “draw period,” even taking time to pay off the balance before you borrow more.
Draw period
The draw period typically lasts for 10 years, and you’re only required to pay interest until that draw period is up. Unlike a home equity loan, which comes with a fixed rate, HELOCs typically have a variable interest rate, so monthly payments can vary.
Closing costs
With either equity loan option, it’s important to note that you will most likely have to pay closing costs (although some lenders may waive them). Either way, know what you’re getting into, says Michael Gifford, CEO and co-founder at Splitero.
“Whether you will have to pay closing costs for a home equity loan or a home equity line of credit (HELOC) depends on the lender and the specific terms of the loan,” he says. “In many cases, borrowers do have to pay closing costs, although the specific fees and amounts can vary. It’s important to review the terms and documentation provided by the lender to understand the specific fees and costs associated with the loan.”
In addition, remember that either type of lending is backed by your house, which means you risk losing your home if you default on the loan.
Requirements for a HELOC or home equity loan
Although home equity lines of credit and home equity loans are two different types of loan products with unique features, the HELOC and home equity loan requirements are quite similar. If you qualify for a home equity loan, chances are good you will also qualify for a home equity line of credit and vice versa.
The primary difference is which way of tapping into your home’s equity makes the most sense for you. Whichever way you decide to go, there are some minimum qualifications that loan applicants must have.
- A minimum amount of equity in the home
- A good credit score
- A history of on-time payments
- Sufficient income
- A low debt-to-income ratio
How much equity you need
Most mortgage lenders require that you have a minimum of 15% to 20% in equity to qualify for a home equity loan or HELOC. Ideally, however, you will have more than 20% equity, especially if you are seeking a fairly large loan amount.
As mentioned, your equity is the difference between your home’s current value and the amount you owe on your mortgage loan. A lender will require you to get a home appraisal to determine the current market value of your house and exactly how much equity you have in the home. This also helps them come up with your loan-to-value ratio, or LTV ratio. This is calculated by taking your current loan balance and dividing it by your current appraised value.
LTV = current loan balance / current appraised value
For example, if your house is worth $300,000 and your remaining mortgage principal is $200,000, your LTV ratio is 66%, which is great. For the most part, to get the best interest rates and loan terms, most lenders want to see an LTV ratio of 80% or less. You may still gain loan approval with a higher LTV ratio, but don’t expect to get the most ideal interest rates.
In general, lenders will allow a loan amount equal to 85% of your combined loan-to-value ratio. This means your primary mortgage plus your desired loan amount can’t be more than 85% of the total value of your home. So with our example, if you borrowed $50,000, your mortgage plus loan would total $250,000, or 83% of the appraised value of $300,000.
current loan balance + new loan < 85% of appraised value
Good credit score
Assuming you meet the equity requirements needed to apply for the loan in the first place, one of the first things lenders are going to do is look at your credit score and credit history. Your credit score is one of the strongest indicators of how likely you are to repay your debts.
Lenders typically have minimum credit score requirements within the mid-to-high 600s, with 700 or higher being a more optimal credit score for approval on a HELOC or home equity loan. In addition, the higher your score the better the interest rate you can get.
If you have a lower credit score, you may still be able to secure home equity financing, but you’ll likely need to be very strong in other areas, such as income or equity requirements.
Pro Tip
If your credit score could use some work (and you want to get the best interest rate possible on a new loan), take some time before you apply to work on paying down high-interest debt and boosting your credit score. You may even benefit from a credit repair service that can help you achieve a better credit score.
Payment history
The most heavily weighted part of your credit scores, and therefore, your credit report, is your history of repaying your debts. And, while your credit score is important, lenders will also take a look at your record of paying your debts on time.
Debt payments — both on time and late — are regularly reported to the three major credit bureaus so it’s easy for potential lenders to see if you have a reliable payment history. If you’re ever late on payments, or worse, miss a payment, a lender may not see you a safe applicant to borrow money.
Employment and income information
Another aspect that lenders look at is your income and employment history. For one, they want to see that you have sufficient income to be able to add another monthly payment to your budget. Lenders also like to see that your income comes from steady unemployment, so they’ll want to verify how long you’ve been at your job.
Debt-to-income (DTI) ratio
Related to your income, mortgage lenders also want to see how much debt you have in relation to your income. This is known as your debt-to-income ratio, or DTI ratio, and you can calculate it by taking your total monthly debt payments (such as any car loans, mortgage, or credit cards) and dividing it by your gross monthly income. Your gross monthly income is your paycheck before any taxes or other deductions are taken out.
DTI ratio = total monthly debt payments / gross monthly income
The reason that DTI is so important to lenders is because even if you have a good income, if too much of it is already being used to pay for your other monthly debts, you may not look like a good candidate to a lender. Ideally, your DTI ratio should be no more than 43%, although that can vary by lender and depend on other aspects of your loan application.
HELOC vs. home equity loan: Which is better?
The method you use to tap into your home’s equity is largely a matter of your personal choice, but there are some factors that may help you to decide which is the best option for you. Keep in mind, though, that there are certain expenses you should NOT use a home equity loan for, as explained by Craig Garcia, president at Capital Partners Mortgage.
“Typically, financial advisors would advise you against using your home equity to fund investments in things that depreciate, or to fund lifestyle expenses,” he says. “Home improvements, which will increase the value of the asset you are borrowing against, could be a very good use of (home equity) proceeds, however.”
Typically financial advisors would advise you against using your home equity to fund investments in things that depreciate, or to fund lifestyle expenses. - Craig Garcia, president at Capital Partners MortgageClick to Tweet
Home equity loan
Home equity loans are often best if you know exactly how much money you need and want to receive it in one lump sum, rather than drawing on it gradually. A home equity loan can also be a good choice for those who want a set repayment period, a fixed interest rate, and predictable monthly payments.
HELOC
If you’re not sure exactly how much money you need and/or you have multiple projects you’re planning to finance, then a HELOC’s revolving credit line might be a better fit for you, suggests Garcia. Plus, sometimes variable interest rates can work to your advantage.
If you like the opportunity to tap into an available credit line in the future — the HELOC is the only mortgage vehicle that would allow you to do this. Also — the HELOC (interest rate) is going to be adjustable — and if you believe that short-term rates are likely to be coming down from here (many do) — this would be the better option,” he says.
Alternatives to HELOCs or home equity loans
If you don’t meet the requirements to get a home equity line of credit or loan, or just decide those options aren’t right for you, you may want to consider some other ways to finance your goals.
Personal loans
Most personal loans aren’t secured loans like HELOCs or home equity loans, so their interest rates are typically much higher. However, your house isn’t at risk if something happens and you can’t repay the loan. In addition, you won’t have to pay closing costs with a personal loan, but you may have to pay an origination fee of up to 10% of the loan.
Cash-out refinancing
A cash-out refinance is another way to grab equity from your home, but instead of having a second mortgage, you basically swap out your existing mortgage for a larger loan and take the difference (your equity) in cash.
This can be a better option for borrowers who don’t want an additional mortgage payment. But, because of the larger loan size, a cash-out refinance may be harder to qualify for and may have higher interest rates.
Home equity investments
If you don’t want to take on any new debt but still want to access the equity in your home, a home equity investment (also known as a shared equity agreement) might be a good option to look into.
Basically, you sell a percentage of your future equity for a one-time payment. This way there are no monthly payments or interest and you only have to repay the money when you sell the house or the contract is up.
How to build home equity faster
Every time you make a mortgage payment, you’re building equity in your home. But it can be slow going, especially since mortgage payments also typically include taxes, homeowners insurance, and interest payments along with the principal. But there are a couple of ways to build equity in your home even faster.
Pay more than your minimum monthly payment
If you can manage to pay a little extra on your mortgage some months and request that it be credited to the principal balance, you can build equity much faster. As an added bonus, this cuts down on how long it’ll take you to pay off your mortgage balance so you save money on interest as well.
Make improvements on the home
If you fix up your house, it can add value to the home which also helps build your equity. And while it’s your house, and you can make any improvements you want, it’s good to be aware of the upgrades that will add the most value to your home. Some improvements to consider are new doors, windows, siding, and minor kitchen and bath remodels.
On a similar note, it can also be useful to know what kinds of home renovations may actually detract from your home’s value and/or make it harder to sell. For example, if you think putting in a swimming pool will increase your home’s value, you may want to think again.
Key takeaways
- Requirements for a HELOC or home equity loan include a respectable credit score, reliable payment history, a low debt-to-income ratio, and enough equity in your home to qualify.
- Common uses for a home equity loan or home equity line of credit are to consolidate debt, pay for education expenses, or make improvements to your home.
- A home equity loan pays you a lump sum of money in exchange for a fixed rate and equal monthly payments, whereas a HELOC is a revolving credit line with a variable interest rate.
- The main drawback of a HELOC or a home equity loan is that they’re secured loans, so you risk losing your house if you fail to repay the loan.
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