Homeowners who have been thinking about borrowing against the equity in their homes probably know about the home equity loan and home equity line of credit (HELOC). Borrowers receive a lump sum loan amount that they repay monthly over 10 to 15 years at a fixed interest rate.
A HELOC gives borrowers the option of taking a lump sum payment or using a line of credit up to a specified dollar amount in smaller amounts as needed. They usually have shorter terms as well as adjustable interest rates.
How Do the Requirements Vary by Product?
For the most part, the requirements for a home equity loan and HELOC are pretty similar for each lender. In both cases, the lender evaluates the risk associated with giving the borrower a maximum dollar amount against the equity in a collateral property. Since the borrower could potentially borrow the same amount with either a home equity loan or HELOC, the requirements are the same.
Income & Credit Score
First, borrowers need to have stable monthly income for a period of 1 to 2 years as well as a good credit history. Borrowers should have a credit score of at least 620, but a higher credit score improves the probability of approval.
Amount of Equity
Second, borrowers must have at least 15 percent to 20 percent equity in the property. That means the loan-to-value ratio without the home equity loan or HELOC needs to be below 80 percent. A lower loan-to-value ratio increases the borrower’s probability of approval. The loan-to-value ratio also determines the maximum amount of the loan or line of credit that the lender will extend to the borrower.
The combined debt of the outstanding mortgage balance and loan or line of credit cannot exceed 85 percent of the home’s value. So, if a borrower starts out with an 80 percent loan-to-value ratio, the home equity loan or HELOC won’t exceed 5 percent of the home value. If the loan-to-value ratio is only 60 percent, a borrower might be able to get up to 25 percent of the home’s value.
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Third, lenders consider the borrower’s debt-to-income ratio. This is the ratio of all monthly debt obligations, including the payment on the new home equity loan or HELOC, divided by the borrower’s gross monthly income. A higher debt-to-income ratio increases the borrower’s probability of default, so lenders prefer to see low overall debt levels.
This is where the requirements may vary a little for the home equity loan and line of credit. Lenders do not want the debt-to-income ratio to exceed 43 percent. Some lenders may allow a maximum debt-to-income ratio of up to 50 percent for a HELOC. Again, the closer the borrower is to the maximum debt level, the lower the probability of approval.
How Do the Requirements Vary by Lender?
The underwriting process and requirements are different for every financial institution. This rule applies to all types of debt instruments a financial institution may offer. Each financial institution has its own level of risk tolerance, models for probability of default, and underwriting formula.
Searching for information online, borrowers can find that each lender provides its own guidelines about credit scores and maximum loan amounts. Some financial institutions have a higher tolerance for risk and thus may approve a borrower who could not get approved at a bank across the street.
There are, however, some general rules of thumb about underwriting requirements and financial institutions. Credit unions tend to have more flexibility in their guidelines than other banks. They generally don’t provide high-risk financial services to businesses and can accept a higher level of risk from credit union members.
Branch banks tend to be relatively strict about their guidelines and underwriting standards when compared to credit unions. The difference between traditional banks and online lenders, however, is not as clear.
Some online lenders are known to provide very low lending rates, but those lenders typically have high standards for loan approval. Their guidelines may be much higher than those of a traditional bank. Other online lenders have lower lending standards than traditional banks and credit unions. These lenders typically cater to borrowers with lower credit scores and charge higher interest rates.
Are There Any Federal or State Lending Requirements?
There are a few federal and state regulations regarding home equity loans and HELOCs. The federal government sets a maximum legal interest rate for a HELOC to no more than 10 percent above the U.S. Treasury rate set for second liens.
States may have individual laws limiting how much lenders can charge for origination fees and other closing costs. Federal regulations also set the 43 percent maximum debt-to-income ratio on home equity loans.
Finally, a change to federal tax law limited the tax deductibility of mortgage interest on home equity loans and HELOCs. Borrowers can only deduct the interest paid on either loan option if they use the proceeds for a major home improvement.