One of the biggest perks of home ownership is accruing equity. Even if you still owe money on your home, as you continue to pay off your mortgage, you gain more and more equity in the ownership of your home. You can then use this equity ‒ balanced against your currently owed mortgage ‒ as collateral for either a home equity line of credit (HELOC) or a lump-sum home equity loan.
Home equity loans and HELOCs are secured against the value of your home equity, so interest rates tend to be both fixed and lower than those associated with, say, personal loans for debt consolidation. But remember, because you are leveraging the value of your equity in your home, failure to make payments on time can result in lenders claiming the rights to your home.
When used responsibly, a home equity loan can be used as a resource to make home renovations or pay off other expenses. Let’s take a look at some of the things your bank will consider before approving your loan.
What do banks consider when approving a home equity loan?
Your current home equity
Your home equity loan is going to be leveraged against how much equity you currently have in your home, so naturally this is the first thing a lender will look at when reviewing your application. Lenders typically want to see that you have equity valued at 15% to 20% or more of your home’s market value before approving you.
To calculate this value, subtract your current mortgage balance from your home’s current market value. For example, if your home is worth $500,000 and you owe $375,000 on your mortgage, then you have $125,000 in equity, or 25%, which puts you in a good position for approval.
Your debt-to-income ratio
Just like any other loan or line of credit, lenders want to ensure that you’ll be able to make the proper payments on your home equity loan on time. Lenders want to see a debt-to-income ratio of no more than 43%. In other words, no more than 43% of your monthly income should go toward expenditures like mortgages, car payments, credit card payments, and student loans.
To calculate this, divide your total monthly payments by your gross monthly income and multiply the result by 100. For example, if your monthly expenditures total $2,800 and your monthly income is $6,700, then your debt-to-income ratio is around 42% ‒ just within the average range for approval. As your debt-to-income ratio increases, your chance of approval decreases because lenders might perceive you as too much of a financial risk.
Your credit score
Your credit score plays an important role when it comes to getting approved for any kind of loan, and home equity loans are no different. Lenders are much more likely to approve borrowers with scores in the mid-600 range or better, and a score exceeding 700 is likely a guarantee, as long as you meet equity requirements.
A lower credit score doesn’t necessarily mean you’re entirely out of the running. It isn’t unheard of for lenders to approve people with scores in the low 600s, but you might need to have a bit more equity in your home to serve as a bargaining chip. It is always in your best interest to improve your credit score as much as possible before applying for any kind of loan.
By John DeGregorio
John DeGregorio is a finance writer based in Brooklyn, NY. He studied Journalism & Media at Rutgers University.