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If your house is paid off and you need access to funding, you might be wondering if a home equity loan is an option for you.
First, a home equity loan is a type of loan in which the borrower’s home serves as collateral for the borrowed funds. It is a secured loan that allows borrowers to access some of the funds from the equity built up in their home.
A mortgage and a home equity loan are two separate loans, so a homeowner does not need to have a mortgage in order to get a home equity loan. In most cases, having a paid-off house can actually help your chances of getting approved for a home equity loan.
The amount you can borrow will depend on a variety of factors including your loan-to-value ratio, credit history, and debt-to-income ratio.
What is Loan-to-Value (LTV)?
Loan-to-value is a ratio that lenders use when they consider underwriting a new loan. The ratio is calculated as the current outstanding loan balance divided by the market value of the property. The difference between the loan amount and the value of the property is the equity stake that the owner has in the property.
When you first purchase a property and take out a new mortgage, you might have around an 80 percent loan-to-value ratio with a 20 percent down payment. Lenders consider lower loan-to-value ratios to be less risky. When you have paid off your home, your loan to value ratio is actually 0 percent because you have 100 percent equity ownership in the home and no outstanding loan balance. This is the least risky situation from the perspective of the lender.
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How to Apply for a Home Equity Loan After Your Home is Paid Off
You can apply for a home equity loan by visiting a local lender’s branch office or filling out an online application. You’ll need to provide the same types of documentation that you do when you apply for a mortgage.
Along with the information on your application and your credit report, the lender will want to see your pay stubs, W-2 forms, documentation of other sources of income, and the most recent monthly statements on all outstanding debts. The lender will also want to obtain an appraisal report in order to determine the current market value of the property, as well as at least 2 years of tax returns.
The lender will evaluate your credit history and total outstanding debt payments as part of the underwriting process to see if you meet the requirements. This is where it will help you to have paid off your home.
You established good borrowing behavior by paying off the debt, you no longer have that debt adding to your overall debt calculation, and you will be able to access the maximum amount of money that could be available based on the current market value of your property.
Here’s How it Works
This example shows how a lender evaluating an application for a home equity loan uses a loan-to-value calculation called a combined loan-to-value (CLTV) ratio. This ratio adds the combined amount of outstanding debt from the mortgage and home equity loan and then divides that amount by the total property value:
CLTV = (outstanding balance on mortgage + outstanding balance on home equity loan) / home value
CLTV x home value = total outstanding balance on mortgage and home equity loan
Lenders generally don’t want the CLTV to exceed 85%. So, if you have a home value of $250,000 and have paid off your home, you could potentially borrow up to $212,500 with a home equity loan.
0.85 x $250,000 = $212,500
On the other hand, consider a situation where you have not paid off your home. Assume you have an outstanding mortgage balance of $150,000 on that $250,000 home. The calculation above showing the maximum dollar amount of your combined loans has not changed. You can still have a combined outstanding balance of $212,500. Now, however, that has to include your mortgage balance of $150,000. What’s left over is the maximum dollar amount you can borrow in a home equity loan: $62,500.
$212,500 – $150,000 = $62,500
So, you can see why having your home paid off is actually beneficial to your home equity loan application. However, it is important to mention that even though there is an allowable amount to borrow, you should not borrow more than is needed for the purpose of the loan.