Home equity financing is about the cheapest money available, because the loans are secured by real estate -- an asset that usually increases in value and is impossible to move. However, mortgage lenders don't hand them out to just anyone -- you'll have to qualify. Here's how to get a home equity loan.
Which Home Equity Loan?
Home equity financing takes two forms -- loans, also called second mortgages, and home equity lines of credit, or HELOCs. Each is better suited for certain uses, and each has its own qualifying requirements.
Home equity loans deliver a lump sum at closing, which is paid back in monthly installments over a fixed term -- usually five to 15 years. Typically, the interest rate is fixed and the payment does not change. These fixed loans are best when you know how much money you need, and you need it all at once -- for example, to consolidate debt or pay a builder for a home addition.
HELOCs are revolving lines of credit that can be tapped as needed up to your credit limit. Payments are calculated using the loan balance and the current interest rate, which is variable. HELOCs are very flexible and best-suited when you know you'll be paying money over time and aren't sure how much you'll need -- for example, to pay collecge tuition over four years or provide emergancy cash for yoour business.
Qualifying for a Home Equity Loan or HELOC
The first thing you need for a home equity loan or HELOC is home equity -- your property value must exceed your loan balance. However, mortgage lenders don't lend against all of your home equity -- most will lend up to 80 or 85 percent of your home's value, and a few will go as high as 90 percent. This percentage is called a loan-to-value ratio, or LTV. So, if you have a $200,000 house and owe $140,000 against it, how much can you borrow with a second mortgage?
For an 85 LTV loan, you'll figure it out this way:
- $200,000 * .85 = $170,000 (that's your 85 percent maximum)
- $170,000 - $140,000 = $30,000 (that's what's left after your current loan balance is subtracted)
You can borrow up to $30,000 with an 85 percent LTV second mortgage.
How to Get a Home Equity Loan: Applying
When you apply for your home equity loan, you'll need to prove your income. Lenders analyze your income using either your tax returns (if you're self-employed, have lots of investments or work on commission) and / or your W-2s and pay stubs. They also pull your credit report and go through your monthly payments. Then, they calculate your debt-to-income ratio, or DTI. That's your total monthly payments for housing and debt (not normal living expenses like food and utilities) divided by your total before-tax income.
If you earn $5,000 a month and pay $1,400 a month for your mortgage, property taxes and insurance, and have a $400 monthly car payment, and $250 in credit card payments, you'll calculate your DTI like this.
- Add up your debts: $1,400 + $400 + $250 = $2,050 per month
- Divide the total by your income: $2,050 / $5,000 = .41, or 41 percent
Here are typical lender guidelines for these loans:
- Minimum credit score: 670 for a 75 percent LTV loan, 700 for an 85 percent LTV loan
- Debt-to-income ratio (including the payment for the home equity loan): 50 percent for a 75 LTV loan, 45 percent for an 85 LTV loan
- The interest rate used to calculate your loan payment to get the DTI is the fixed rate for a home equity loan.
- For a variable rate home equity loan or HELOC, the rate used to qualify you is usually higher than the rate you'll be starting with -- the introductory or start rate. Normally, these loans come with a low start rate, but then it adjusts according to an index (usually the Wall Street JournalPrime Rate) and a margin (which is set by the lender). So if your start rate is 2.5 percent, but your margin is 3.00 percent, and the Prime Rate is 3.25 percent, you'll be qualified at a payment based on a 6.25 percent interest rate (3.00 + 3.25 percent). In addition, with a HELOC, you start out with a balance of zero, but the lender qualifies you as though your balance is at your credit limit.
Understand that home equity loans and HELOCs are not standardized like many other mortgage programs, such as the mortgages offered by Fannie Mae, Freddie Mac, and FHA. Guidelines, rates and terms can vary tremendously. To increase your chance of loan approval, try a source like LendingTree, which connects borrowers and lenders, and allows you to get offers from several competing home equity lenders.