Paying your mortgage every month can seem like a chore. But the good news is that as you do so, you’re building equity in your home. Home equity refers to how much ownership you have in the home, measured by its full value minus what you still owe on the mortgage. As your home equity builds, you have the option to tap it for funds through a home equity loan or a home equity line of credit, also known as a HELOC.
Meeting the qualifications for these two products isn’t as simple as just being a homeowner, however. The application process is thorough — similar to when you applied for your mortgage — and the requirements could sometimes be even more stringent.
If you can qualify, though, HELOCs and home equity loans can be used for a variety of purposes from funding a home renovation to consolidating high-interest debt to covering emergency expenses. Learn more about HELOCs and home equity loans, and how to qualify for them.
What are HELOCs and Home Equity Loans?
Both HELOCs and home equity loans allow you to borrow against the equity you have in your home. The home itself is collateral, just as it is for your first mortgage.
“The housing market has gone up, and value has gone up,” says Katie George, principal relationship manager with the real estate department at Addition Financial Credit Union. “People are seeing they have a lot of equity and want to take advantage of that.”
While you can tap the equity in your home through either a HELOC or home equity loan, they have different structures and offer specific features and benefits. The main difference between a HELOC and home equity loan is how you receive the funds.
HELOC vs. Home Equity Loans
With a HELOC, you get a revolving line of credit, similar to a credit card. You’ll have a credit limit set by your lender, and can borrow at your discretion within a timeframe known as the draw period. During the draw period, which is typically 10 years but may vary by lender, you only have to make interest payments, though you can choose to pay more.
Once the draw period ends, you begin the repayment period during which you must pay off both the principal borrowed and interest. Because most HELOCs have variable interest rates, you may not owe the same amount each month, and your payment could increase if rates increase.
A home equity loan is more straightforward. You get a lump sum of money, and then pay it off in fixed payments over a set term.
| HELOC | Home Equity Loan |
| Variable rate (though fixed may be available) | Fixed rate |
| Revolving line of credit | Lump sum of cash |
| Separate borrowing and repayment periods | Typical loan repayment terms |
| Payments can fluctuate | Consistent, predictable payments |
Requirements for a HELOC or Home Equity Loan
Experts say you’ll have the best chance of qualifying for a HELOC or home equity loan if you meet the following requirements:
— Credit score of 660 or higher; above 700 is best
— Loan-to-value ratio of 80% or lower
— Debt-to-income ratio under 50%
You may still qualify with some lenders if you don’t meet these requirements, but you will likely see a higher interest rate and may not be able to borrow as much. While requirements are similar for both products, a home equity loan may be slightly easier to qualify for, says Giles.
“The reason for this is a HELOC, being a line of credit, requires the lender to qualify the borrower assuming the entire line amount is utilized, and the interest rate has gone up, typically 2% above the current rate,” Giles says. “Therefore, the HELOC tends to have a higher qualifying payment calculated into the borrower’s debt-to-income.”
Here’s a closer look at the key requirements.
Loan-to-Value Ratio
LTV measures the amount of money borrowed compared to the full market value of your home. For example, if your home is worth $500,000 and you still owe $200,000 on your mortgage, your LTV is 40%. In this example, it means you have 60% equity in the home.
Many home equity lenders use combined loan-to-value, which combines your outstanding mortgage plus the intended amount of the HELOC or home equity loan, and then measures that against your home’s current value.
Strong Credit
Most lenders will require a credit score of 660 or higher, with higher scores typically receiving a lower interest rate. DiBugnara points out that this can be a higher threshold than is required for a first mortgage, since some loan programs, like FHA loans, allow lower scores.
Stable Employment and Income
Even if you have a perfect track record with your current mortgage, home equity lenders still want to confirm that you have reliable employment and the ability to repay the new loan or credit line, says George. “Sometimes people retire and live on a fixed income, and are surprised that it’s such a big factor to qualify,” she says.
Those who are self-employed may be asked for extra documentation, including two years worth of personal and business tax returns, to prove they have stable income, says DiBugnara.
Debt-to-Income Ratio
The maximum DTI allowance may vary by lender, but 50% will be the highest most will go. “Borrowers should keep in mind that the DTI will include their first mortgage payment and the new home equity payment, along with other outstanding debt,” Giles says.
Many lenders like to see a DTI of 43% or lower for equity loans and HELOCs, says DiBugnara.
[SEE: Best Home Equity Loans]
How to Qualify for a HELOC or Home Equity Loan
If you’re in the market for a home equity loan or HELOC, start by assessing your situation to see if you have a good chance to qualify.
— Check your credit score. If your score is not at least 660, see if there are things you can do to try to make improvements. Scan your credit reports for errors and fix them. Work with past creditors to clear up any delinquencies. And try to pay down any large balances to bring down your credit utilization.
— Estimate your LTV to determine how much you can borrow. See what you still owe on your current mortgage and use online tools to estimate your home value. Then figure out how much you may be able to borrow up to 80% LTV. For example, on a $400,000 home, 80% is $320,000. If your first mortgage balance is $250,000, that means $70,000 in lendable equity remains, says Giles.
— Calculate your DTI. Divide your monthly debt obligations by your gross monthly income. For employed borrowers, the lender may verify your income through pay stubs, W-2 forms or tax returns.
— Get lender quotes. Rates and terms vary by lender, so do some comparison shopping. You may also want to check with the institution that has your first loan to see if there might be relationship perks.
Should You Get a HELOC Or Home Equity Loan?
“There are two things I always stress to borrowers,” says Giles. “Understand your budget and how much you are comfortable paying per month, and, when borrowing, use the funds for something that will put you in a better financial position such as adding value to your home or paying off higher interest debt.”
Expenses you might use a HELOC or home equity loan to cover include home renovations, debt consolidation or rental property purchase. Be mindful that tapping the equity in your home for additional funds isn’t always a good idea. If you’re expecting income disruptions or other difficulties that could make it challenging to take on more debt, a home equity product could put your home at risk for foreclosure.
Which Home Equity Product Is Best for You?
Choosing between a HELOC and home equity loan really depends on your needs. “If you’re going to borrow every single dollar, you may be better off with the loan,” says Ralph DiBugnara, president of Home Qualified, a digital resource for buyers, sellers and realtors.
A home equity loan also may make more sense if you’re looking for a large lump sum of cash up front, says Jon Giles, head of consumer direct lending at TD Bank. “It may be a better option for someone making a large purchase or consolidating debt.”
But if you’re not sure how much money you need, a HELOC gives you more flexibility.
Another thing to consider is what you’re using the money for. “A HELOC is good for when you have recurring expenses like small home improvements where you’re doing a little at a time. You might also just want to have access to the equity in your home — a just-in-case fund,” says George.
HELOC and Home Equity Rates
HELOCs and home equity rates have risen along with other lending products in recent years, but they can still be useful to some consumers. “For the majority of mortgage holders with the lower rates, using a home equity product to access funds while retaining that historically low mortgage rate makes sense,” says Giles.
More recent mortgage borrowers could benefit from comparing home equity and cash-out refinancing options to determine what is best for their situation, he adds.
More from U.S. News
When Does a Reverse Mortgage Make Sense?
Mortgages for Seniors: Everything You Need to Know
Is a HELOC a Smart Way to Pay Off Credit Card Debt?
Requirements to Get a HELOC or Home Equity Loan originally appeared on usnews.com
Update 09/12/24: This story was previously published at an earlier date and has been updated with new information.
