Solved! What Are the Requirements for a Home Equity Loan?

Q: I purchased my home 7 years ago and would like to make some improvements to it, but I need to figure out how to pay for it. A friend recommended looking into a home equity loan to help fund my home improvement project, but I’m not really sure how a home equity loan works or if I would even qualify. What are the requirements for a home equity loan?

A: Your friend is correct: A home equity loan is an excellent option for homeowners looking to pay for expensive projects such as home improvement. The criteria for home equity loan approval can vary among lenders, but in general homeowners must be in good financial standing with a decent credit score, low debt-to-income ratio, and a certain amount of equity in their home. Following approval, the homeowner gets a lump sum of cash that can be used to pay for anything they want—in your case, home improvement. To answer the question “What are the qualifications for a home equity loan?” you’ll first need to have a full understanding of home equity loans in order to find the best one for you.

A home equity loan is a type of second mortgage that helps homeowners access a lump sum of cash from their home’s equity.

Before establishing the requirements for a home equity loan, homeowners will need to understand how this type of loan works. First, what is a home equity loan? In short, it’s a type of loan that a homeowner can take out in order to access the equity (the difference between what’s owed on the mortgage and what the home is worth) in their home. One of the advantages of a home equity loan is that the borrower can use the money to pay for whatever they would like, such as home repairs or improvements, medical or credit card debt, or a child’s college education. The borrower must pay back the home equity loan in monthly installments, similarly to how they pay their mortgage. But if the homeowner defaults on their home equity loan, they may risk losing their home to foreclosure.

How does a home equity loan work? Because a home equity loan is a second mortgage, it will typically have a higher interest rate than a primary mortgage. This is because, in the event of a foreclosure, the primary mortgage would be paid off first, and the home equity loan second. If the home sale price was less than the combined total owed on the first and second mortgages, the home equity loan lender may not recoup its costs in full; a higher interest rate helps balance out the potential loss in this case.

In order to qualify for a home equity loan, borrowers must have a certain percentage of equity in their home.

One of the most important home equity loan requirements is for the homeowner to have a certain amount of equity in their home. The exact amount of equity required can differ from lender to lender, but in general borrowers must have between 15 and 20 percent in home equity. Equity is calculated by subtracting the amount the homeowner owes on the house from its appraised value. For a home appraised at $450,000, a homeowner would need to owe no more than $360,000 to have 20 percent equity in the home. Since house prices fluctuate depending on the real estate market, a homeowner may find that they have more or less equity in their home than they thought if their home’s appraised value is higher or lower than its sale price when they bought it.

Additionally, borrowers must have a good credit score and a low debt-to-income ratio.

In order to qualify for a home equity loan, borrowers must generally have an acceptable credit history and score, and a low debt-to-income ratio. Requirements vary among lenders, but in general a borrower with a credit score of 620 or higher will be more likely to qualify for a home equity loan. Borrowers with “good” or “excellent” credit scores of 670 and above will likely be offered lower home equity loan rates than those whose credit score falls between 620 and 670.

In addition to an acceptable credit score, a borrower must typically have a debt-to-income (DTI) ratio of 43 percent or lower. To calculate DTI, homeowners can divide their monthly debt payments (including auto loans, student loans, personal loans, minimum credit card payments, child support, and alimony payments) by their pretax income. For example, a borrower with a monthly pretax income of $5,000 and monthly debt payments of $1,500 would have a DTI of 30 percent.

Borrowers must show that they have enough income to repay the loan in addition to a history of on-time payments.

As part of the home equity loan application process, borrowers may be required to show the lender proof of income. This helps the lender determine whether the borrower will be able to afford the monthly loan payments. Homeowners will generally need to have at least 2 years of income history to show steady employment and income. Proof of income can include pay stubs, tax returns, or profit and loss statements for self-employed borrowers. Homeowners may want to consider boosting their income before applying for a home equity loan by taking on some freelance or contracting work or asking for a raise from their employer—a higher income will also decrease the homeowner’s debt-to-income ratio, making them more likely to qualify for a loan.

As part of the credit check process, lenders may look at the borrower’s payment history with other lenders. Not only can a history of late payments have a detrimental effect on the borrower’s credit score, but it can also raise red flags for the lender since they risk losing money if the borrower fails to repay the loan.

Homeowners can build equity by making on-time payments and paying extra toward the principal where possible.

When a homeowner first closes on their house, they can build instant equity by putting down a lump sum of cash as a down payment, though not all buyers will be able to afford a large down payment. Homeowners will continue to build equity in their home by making on-time monthly mortgage payments. Depending on their down payment amount, it could take several years of making payments to reach the 20 percent equity threshold.

Homeowners can also make additional mortgage payments as they are able to help them build equity more quickly. For example, they might choose to put a tax refund or a bonus from their employer toward their mortgage to build up equity faster. Some homeowners may be able to pay a higher monthly payment than is required by the lender, which can also help them build equity faster.

If the home’s value increases significantly, homeowners may be able to qualify for a home equity loan even if they haven’t paid much toward their mortgage.

The real estate market fluctuates over time, which means home values can increase or decrease from month to month or year to year. Homeowners who purchased their home at a time when home prices were generally low may be able to qualify for a home equity loan if their home’s value has increased considerably since purchase. Homeowners who have put a lot of work into their home may also find that the home’s value has increased significantly.

Lenders typically require the borrower to pay for a home appraisal to determine the home’s value as part of the home equity loan application process.

Homeowners can get a general idea of their home’s value by requesting a market analysis from a real estate agent, but lenders typically require an official appraisal determining the value of the home in order to approve a home equity loan application. If the appraisal finds that the property’s value has gone up, the homeowner may have 15 to 20 percent in equity even if they haven’t made enough mortgage payments to build that amount of equity.

In general, a lender will order a home appraisal after the borrower has submitted their home equity loan application. Borrowers may choose to pay for an appraisal of their own before applying for a home equity loan to determine whether or not they will qualify—if they find that their home is worth less than they thought, they can look at alternative financing options that don’t require home equity.

Borrowers will also need to pay closing costs when they take out a home equity loan.

Just like a mortgage, a home equity loan comes with closing costs that the borrower must pay when they close on the loan. Closing costs vary depending on the lender, but they may include fees for the appraisal, credit report, document preparation, attorneys, loan origination, notaries, and title search. Closing costs for a home equity loan generally range between 2 and 5 percent of the loan amount—some lenders will allow a borrower to roll the closing costs into the loan amount to avoid paying them out of pocket. Borrowers can ask lenders about home equity loan closing costs when they’re shopping around for quotes from the best home equity loan lenders.

Homeowners may also consider a home equity line of credit or a cash-out refinance to tap into their home’s equity.

A home equity loan is just one option for homeowners looking for how to get equity out of their home. Two common home equity loan alternatives include home equity lines of credit (HELOCs) and cash-out refinances.

With a HELOC, a homeowner will be approved for a revolving line of credit that is borrowed against their home equity. A HELOC works similarly to a credit card; the borrower can take out money up to the credit limit and will make minimum monthly payments or pay off the balance each month. HELOCs have a “draw period,” which is the period of time when the borrower can take out funds from the line of credit. During this period, the borrower may only be required to pay interest. Once the draw period has come to an end, the borrower will enter the repayment period, during which they will make monthly payments that will go toward both principal and interest.

A cash-out refinance is different from a home equity loan and a HELOC, both of which add a second monthly payment to the borrower’s primary mortgage. A refinanced loan replaces the primary mortgage so the borrower will only have one mortgage payment each month. A borrower can choose a refinance for their loan amount, or they may choose to take out a lump sum of cash from their home equity as part of a cash-out refinance. While a basic refinance may reduce the borrower’s monthly mortgage payments, a cash-out refinance will likely increase it, since the loan amount will be higher.

Borrowers will want to consider a HELOC vs. home equity loan, or even a cash-out refinance vs. home equity loan, depending on their needs and wants.

If the homeowner doesn’t meet the qualifications for a home equity loan, they can look into personal loans, credit cards, CD loans, or family loans.

Borrowers who don’t qualify for a home equity loan, HELOC, or cash-out refinance can look to alternatives if they are in need of cash for home improvements, unexpected medical bills, or credit card debt repayment. These home equity loan alternatives include personal loans, credit cards, CD loans, and family loans.

Personal loans generally come with a fixed interest rate and fixed monthly payments and have average terms of 1 to 7 years. Because most personal loans are unsecured, borrowers will likely be required to pay a higher interest rate since an unsecured loan is seen as riskier than a secured loan. However, personal loans may be a better option for homeowners who don’t have enough equity in their home or who would rather not tap into their equity and risk losing their home.

Credit cards can be useful tools if used responsibly. Borrowers with good credit histories may qualify for a 0 percent APR introductory rate, which means they won’t be required to pay interest on purchases during a set period of time, typically 6 to 21 months.

Borrowers who have a certificate of deposit (CD) savings account may want to look into a CD loan, which is a type of secured loan that’s tied to a CD account. The main pro of CD loans is that they generally have lower interest rates than home equity loans, making them a potential option for homeowners who want to finance a short-term home improvement project without touching their home equity.

Finally, homeowners may consider asking a trusted family member for a loan. In general, family members are less likely to charge high borrowing costs, and depending on the family member, they may be willing to give the borrower an interest-free loan. However, borrowing money from family can be risky; failing to repay a loan can result in irreparable damage to the relationship.

A home equity loan is a good option for qualified homeowners who need cash to make home improvements or pay off an unexpected bill.

While there are several home equity loan pros and cons, a home equity loan is generally a good option for a homeowner who has built up at least 15 to 20 percent equity in their home. Home equity loan lenders generally don’t specify what the borrower can spend their money on, which means homeowners can use their equity to pay for a variety of expenses. Using the money to pay for a home improvement with a high return on investment (ROI) can be a good move since the homeowner may make an extra profit on the home when they sell it. It can also be a lower-interest option to a credit card or personal loan for homeowners facing an unexpected bill, or who are trying to help pay for a child’s college education. Homeowners will want to shop around to find the best home equity loans that will fit into their budget.