If you’ve been in your home for some time, you’ve likely built up a significant amount of equity. Or maybe you recently purchased, and the thriving real estate market has provided a quick boost to your equity. Either way, you may be considering a home equity line of credit and wondering what you’ll need to qualify. It depends on the lender, but you’ll discover the home equity line of credit requirements in this guide and other alternatives, like a cash-out refinance, that may be worth exploring.
What Is a Home Equity Line of Credit?
Also known as a HELOC, a home equity line of credit lets you tap into your home’s equity. It’s secured by your property and gives you access to up to 85 percent of the equity you’ve built up.
The lender will subtract the remaining balance on your mortgage and any other loans against your home from your property value to calculate how much equity you have. For example, assume you purchased your home for $375,000 and have since paid down $100,00 of the principal, leaving you with a $275,000 mortgage balance. If your home is now worth $425,000, you could qualify for a HELOC of up to $86,250 ($425,000 * .85 – $275,000).
How Does a Home Equity Line of Credit Work?
If you’re approved for a HELOC, you’ll get access to a revolving credit line that operates like a credit card. You can spend up to the limit during the draw period, generally around ten years. Each time you remit payment over the required payment for interest, the funds become available for use.
Once the draw period ends, the lender requires payment for the outstanding balance in monthly installments for up to 20 years. However, the amount you pay each month could change since most HELOCs come with variable interest rates.
This flexibility makes a HELOC a dynamic tool for managing finances. Still, it also requires careful budgeting to accommodate potential fluctuations in interest rates and the corresponding impact on monthly payments. Furthermore, the ability to borrow funds repeatedly can assist with ongoing projects or expenses, which helps ensure you have continued access to funds as your financial needs change over time.
What Can You Use a Home Equity Line of Credit For?
There are usually no restrictions on using the funds drawn from a HELOC. Even better, you’re not obligated to withdraw the entire amount and only pay interest on what you borrow.
Many homeowners pay down high-interest debt, boost emergency savings, contribute to their nest egg, start a business, make big-ticket purchases or pay for costly home improvements.
Furthermore, a HELOC can be an invaluable tool for managing unexpected financial challenges, offering a safety net that can be accessed when needed. It’s also ideal for funding education expenses or investing in significant life events like weddings or once-in-a-lifetime trips.
With careful planning, a HELOC can serve as a strategic component in a comprehensive financial plan. It provides the liquidity to seize opportunities or navigate economic uncertainties without disrupting long-term investment goals.
What are the Key Requirements for a Home Equity Line of Credit?
When you’re considering applying for a Home Equity Line of Credit (HELOC), understanding the essential qualifications is vital. The lender determines the eligibility criteria, but you should meet these guidelines to qualify:
- Have a credit score in the 600s (average is at 620)
- Have a debt-to-income (DTI) ratio of no more than 43%
- Own a home that’s valued at or over 20% of your outstanding mortgage balance (some lenders allow up to 15 %)
Below is a closer look at the income, credit score, home equity, DTI and documentation requirements for HELOCs.
Income Stability
Your income stability is a primary consideration for lenders. They need to confirm that you have a consistent and reliable income stream to cover the payments on a HELOC. When you apply, you’ll be asked to provide proof of income, which could include recent pay stubs, tax returns or other financial documents that verify your earnings.
Credit Score Demands
Your credit score significantly impacts your eligibility for a HELOC. Most lenders require that your score falls within the mid-to-high 600s at a minimum, with better rates often available to those with scores of 700 or higher. This three-digit number indicates your creditworthiness or past ability to manage credit. It also sheds light on the likelihood of defaulting on future debt payments.
Home Equity Requirements
To qualify for a HELOC, you typically need to have at least 15 to 20 percent equity in your home. Your home’s equity is the portion of your property that you actually own – the value of your home minus any outstanding mortgage balance. Lenders often allow you to borrow up to a certain percentage of this equity amount.
Debt-To-Income Ratio
Your DTI ratio shows how much of your gross monthly income goes towards paying debts. Lenders use this ratio to assess if you can afford a new loan. A lower DTI ratio is preferable, as it suggests you have a good balance between income and debt, which could lead to better HELOC terms and interest rates.
Documentation Requirements
You’ll also need to provide documentation similar to what was requested when you initially took out a mortgage loan. This could include:
- Income and employment information: most recent paystubs and W-2 forms or two years of tax returns and Form 1099s (if self-employed) and rental income documentation (if applicable)
- Asset information: statements from the prior two months for bank accounts, retirement accounts, brokerage accounts and other assets
- Debt information: monthly payments for outstanding debt and information about current real estate debt
An Important Note
Remember, home equity line of credit requirements can vary from lender to lender. So be sure to check with multiple providers to find the best fit for your financial situation. Each lender will have different thresholds for credit scores, home equity and income stability. Furthermore, repayment periods and whether you get a fixed interest rate may also vary, affecting the long-term costs of your home equity line of credit.
Alternatives To a Home Equity Line of Credit
If you want to access equity, review some alternative ways to access your home equity:
Home Equity Agreement
A home equity agreement provides a lump sum of cash upfront, which can be particularly beneficial for those needing to cover immediate expenses without the financial strain of monthly payments. This type of agreement is not a loan but rather an investment in your property’s potential appreciation.
As a homeowner, you maintain the right to live in and use your home as usual, while the investor’s return is contingent on the home’s performance in the market. It’s a flexible financial option that aligns the interests of both the homeowner and the investor, as both parties stand to gain from the property’s future success or share the risk of any potential downturn in the housing market.
Home Equity Loan
A home equity loan also allows you to convert your equity to cash. They act as a second mortgage, and most lenders will approve you for up to 85 percent of your home’s equity. However, you’ll receive the funds in a lump sum and must pay interest on the entire amount over a 20 to 30-year term.
The upside is the interest rate on home equity loans is typically fixed, so you’ll have the same monthly payment over the life of the loan. But you risk losing your home to foreclosure should you face financial hardship and fall behind on your loan payments.
Cash-Out Refinance
A cash-out refinance swaps out your current mortgage with a new one. If you have enough equity in your home, you can possibly pull it out in cash at closing. You’ll also get new terms, which means you could end up with a higher interest rate than you currently have and spend more over the loan term.
To illustrate how it works, assume your home is worth $425,000 and you owe $310,000. If your lender approves you for a cash-out refinance for 80 percent of your home’s equity, you could pull out equity of up to $30,000 ($425,000 * .80 – $310,000). You’ll get this amount when you close on the loan. The lender will pay off your existing mortgage, and the principal balance on your new mortgage will be $340,000 ($310,000 + $30,000).
While this alternative may seem viable, as you’ll only make payments on one loan, your monthly payments could stretch your budget thin.
Should You Get a Home Equity Line of Credit?
It depends on your personal financial situation and goals for the money. For example, a HELOC could be suitable if you have good or excellent credit, as it generally has more competitive interest rates than other home equity loan products. But if your credit score is lower or you’d prefer a debt-free way to tap into your equity, a home equity agreement could be a better fit. There are no stringent qualifications, and you won’t pay hefty closing costs, monthly payments or interest. Plus, the approval process is straightforward.
Before you move forward, weigh the costs and benefits of HELOCs, home equity agreements and other alternatives to access your home’s equity. That way, you’ll have all the information you need to make an informed decision. If you’re looking for another alternative to a home equity line of credit, consider getting a cash-out refinance instead. A cash-out refinance is often the easiest to qualify for and generally has much lower interest rates.
