Homeownership comes with many perks, including building equity. As you pay off your mortgage, your home’s value less what you owe, also known as your home equity, should increase. If you build up enough equity, you could tap it for funds through a home equity loan or a home equity line of credit, also known as a HELOC.
But it takes more than owning a home to meet the requirements for a home equity loan or HELOC. HELOCs and home equity loans can be used for a variety of purposes, but to make the most of these potentially risky debt products it’s important to understand just what they are and how to qualify for one.
What are HELOCs and Home Equity Loans?
Both HELOCs and home equity loans, sometimes called second mortgages, use your home as collateral. This means that if you don’t repay your lender, it can seize your home as payment. While you can tap the equity in your home through both a HELOC and home equity loan, they each offer unique features and benefits.
A main difference between a HELOC and home equity loan comes in how you receive the funds. With a HELOC, you use your home to secure a revolving line of credit. You’ll have a credit limit set by your lender and can then use as much as you need within that limit during a set time known as the HELOC’s draw period. You may access funds by using checks or a credit card connected to the account.
In contrast, a home equity loan provides a lump sum of money that you must repay over a predetermined amount of time, like a personal loan. The rate and term are normally fixed with equal monthly payments. The fixed repayment structure of home equity loans can make them good options for people who need consistency and predictability, says Jon Giles, head of consumer direct lending at TD Bank.
HELOCs have a different repayment structure. “HELOCs allow homeowners to draw funds from their credit line as they need them and only pay interest charges on the amount withdrawn,” Giles says.
After the HELOC’s draw period, you will need to pay off the principal and interest, unless the lender allows you to renew your credit line. Most HELOCs have variable interest rates, so you may not owe the same amount each month.
How to Qualify for a HELOC or Home Equity Loan
In recent months, home equity lenders have offered credit largely to lower-risk borrowers with high credit scores, lower debt-to-income ratios, or DTI, and lower combined loan-to-value ratios, or CLTV, says Ken Flaherty, senior consumer lending analyst at Curinos.
“That doesn’t mean that credit isn’t available for higher-risk borrowers, but the requirements to obtain home equity products have become tougher,” Flaherty says.
Experts say you’ll have the best chance at qualifying for a HELOC or home equity loan if you meet the following requirements:
- Credit score of 660 or higher, although above 700 is best
- Loan-to-value ratio, or LTV, of 80% or lower
- DTI under 50%
You may still qualify 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.
You can calculate your DTI by dividing 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. If you’re not traditionally employed – and active employment isn’t normally a requirement, according to Flaherty – you’ll need to provide other proof of sustainable income, such as retirement or investment income.
“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, if both loans will remain,” Giles says.
LTV measures the percentage of your home’s value covered by your mortgage. For example, if your home is worth $500,000 and you still owe $200,000 on your mortgage, your LTV is 40%. Some home equity lenders use CLTV, which combines your outstanding mortgage and the potential amount of the HELOC or home equity loan, then measures that against your home’s current value.
How Much Equity Can You Borrow with a HELOC or Home Equity Loan?
Experts say most lenders allow you to borrow up to 80% or 85% of your home’s appraised value minus what you still owe on your mortgage or other loans on your home.
For example, if your home is appraised at $500,000 and your lender allows you to borrow up to 85% of the home’s value, you could get up to $425,000. If, however, you still have a $200,000 mortgage on the property, you would only be able to get up to $255,000 from the HELOC or home equity loan.
Should You Get a HELOC Or Home Equity Loan?
Many borrowers are turning to HELOCs and home equity loans given recent market conditions, Giles says. Borrowers are doing this “in order to retain their existing low mortgage rate and payment that they were able to obtain in recent years while accessing money through the home equity product to strengthen their financial position,” Giles says.
But given the fact that defaulting on a HELOC or home equity loan could cost you your home, it’s important to carefully weigh the risks and benefits before using either option, even if you qualify.
Expenses you might use a HELOC or home equity loan to cover include:
- Home renovations. “If you are looking to use renovation projects to increase the value of your home, tapping into home equity can be a smart way to reinvest in your property,” says Matt Vernon, head of retail lending for Bank of America. “Tapping home equity can also be a good way to handle unexpected costs like medical bills, particularly if you’ve used up your emergency fund and can afford the monthly payments.”
- Debt consolidation. With their lower interest rates, a HELOC or home equity loan can be an effective way of consolidating existing debt into one payment, provided you’re able to pay it off.
- Higher education. Depending on rates and the types of student loans still available to you, it may be less expensive to use a home equity loan or HELOC than additional student loans to cover education expenses for you or your child.
- Second home or rental property purchase. It can also be effective to use a HELOC for a second home purchase, especially if it will be a rental property that will “bring in cash flow necessary to make the payments, and where the second home will be increasing in equity as time rolls on,” says Mark Charnet, founder and CEO of American Prosperity Group. You can also use a home equity loan for this purpose.
- Other large purchases. Since your home is used as collateral, the interest rates with HELOCs and home equity loans are generally more favorable than with credit cards or other unsecured borrowing options. This can make HELOCs and home equity loans good options for borrowers with stable incomes who want additional funds for large expenses.
However, tapping the equity in your home for additional funds isn’t always a good idea.
“Broadly speaking, homeowners who are facing expected income disruptions, making it difficult to repay their debt obligations in coming months, should probably avoid taking on additional debt,” Flaherty says.
While securing additional access to cash for looming income disruptions may seem like a good idea, it’s often not worth the risk of foreclosure and negative impact on your credit if you’re unable to repay the debt.
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