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Home Equity Loan Requirements in 2021
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One of the many perks of homeownership is having the opportunity to borrow against the equity you build in your property. But before you do, it’s important to understand key home equity loan requirements, along with the benefits and drawbacks of this loan product.
What is a home equity loan?
A home equity loan allows you to borrow against the equity you have in your home. Equity is the difference between your outstanding mortgage balance and your home’s market value.
This type of loan is also called a second mortgage, because it takes second priority after your first mortgage when debts need to be repaid in a foreclosure. Your home is used as collateral — as is the case with the first mortgage you took out to buy your home.
Home equity loan terms often range from five to 20 years, and can sometimes go up to 30 years. The loan is paid to you in a lump sum, and you’re generally given both a fixed interest rate and fixed monthly payments as part of your repayment agreement.
HEL vs. HELOC
A home equity loan (HEL) shouldn’t be confused with a home equity line of credit (HELOC). Rather, a HELOC works similar to a credit card: You use only the money you need and make monthly payments based on your outstanding balance, paying interest only on the amount of the credit line you actually use.
You can take out as much (or as little) money as you need from your credit line until you reach the limit. Unlike home equity loans, HELOCs typically come with variable interest rates. Like a HEL, however, a HELOC is secured by your home and you can lose it to foreclosure if you don’t repay it.
2021 home equity loan requirements
Here’s what is needed for a home equity loan in 2021:
Before getting a home equity loan, you’ll need to have enough equity in your home. Home equity lenders typically cap loan amounts to 85% of your available equity, according to the Federal Trade Commission.
Your loan-to-value (LTV) ratio should be 85% or lower, meaning you still have at least 15% equity in your home after taking out a home equity loan. For example, say your home is worth $300,000 and you owe $150,000 on your mortgage: You have $150,000 in equity and your current LTV ratio is approximately 50% ($150,000/$300,000). If you take out a $100,000 home equity loan, your combined LTV ratio would be about 83%.
Your lender may order a home appraisal to verify your home’s value and calculate your available equity.
You’ll need at least a 620 credit score to get a home equity loan, but your lender may have a higher minimum, such as 660 or 680. To get your best rates, shoot for a credit score of 740 or higher, but know that it’s possible to qualify for a home equity loan with bad credit.
You’ll need to show you earn enough money to comfortably manage your monthly obligations, plus a new home equity loan. Your debt-to-income (DTI) ratio — the percentage of your gross monthly income used to repay debt — tells your lender whether you can handle another loan or if you’ll be stretched too thin.
Your DTI ratio shouldn’t exceed 43% for a home equity loan, but you may qualify with a ratio as high as 50%, depending on your lender.
Credit and payment history
Lenders must also determine whether you’re a creditworthy borrower. They’ll review your overall credit profile, which includes:
- The types of credit accounts you have
- How much you owe on those accounts
- The length of years the accounts have been open
Your payment history is also scrutinized — whether on-time or late — as well as any accounts you have in collections.
Pros and cons of a home equity loan
Consider the following pros and cons of a home equity loan as you decide whether it’s the right choice for you.
You’ll have fixed monthly payments. Because it’s an installment loan with a fixed rate over a set term, your home equity loan will have the same payment amount each month.
Your interest rate will be lower than some other products’ rates. In many cases, home equity loans have lower interest rates than credit cards or personal loans. At time of publication, the average rate for a $25,000 home equity loan was less than 6%, according to data from ValuePenguin, a LendingTree website.
You may reap some tax benefits. Home equity loan interest is tax-deductible through the mortgage interest deduction, though only if your loan proceeds were used to buy, build or substantially improve your home. You’re not allowed to deduct interest if the loan was used for personal expenses, such as consolidating debt or paying college expenses.
You’ll lose some of your home equity. It takes time to gain equity in your home. When you borrow against it, you’ll need additional time to rebuild the equity you once had. This could be problematic if you have to sell your home soon, as you’ll pocket less money at the closing table.
You’re at greater risk of going underwater. If home values in your area drop, you could go underwater on your first mortgage and home equity loan, meaning you owe more on those loans than your home is worth. This can create issues when you’re ready to refinance or sell.
You could lose your home to foreclosure. The biggest drawback to using a home equity loan is that it puts your house on the line. If you fail to repay your loan, the lender has the right to foreclose on your home to recoup your debt.
Who should get a home equity loan?
Homeowners can apply for a home equity loan and use the funds for a variety of purposes. Common reasons for borrowing against your home equity include:
- Covering home improvement costs
- Consolidating high-interest debt
- Paying for higher education expenses
- Buying an investment property
- Starting a business
Still, not every use of a home equity loan is financially sound. Review the best and worst ways to leverage equity.
Home equity loan alternatives
If you’re concerned about meeting home equity loan qualifications, check out the following alternatives.
- Home equity line of credit. HELOC requirements are somewhat similar to those of a home equity loan, but remember that it’s a revolving credit line and you only make payments based on the amount used, plus interest. If you need flexibility and you’re able to pay off your loan in a shorter time frame, a HELOC may be a better choice.
- Cash-out refinance. A cash-out refinance involves replacing your old mortgage with a new one that has a larger principal balance, and pocketing the difference between the two loan amounts in cash. Compare the differences between cash-out refinancing, home equity loans and HELOCs before moving forward.
- Personal loan. Depending on your credit score and income, you can take out an unsecured personal loan instead of borrowing from your home’s equity. There’s no collateral required to borrow the loan, but it may come with a higher interest rate and a shorter repayment term.
- Credit card. A credit card can be a quicker way to access the money you need. Carrying a balance on your credit card is pricey, though, as credit cards usually have higher interest rates than the aforementioned alternatives.