Home Equity Loan: Basics
Learn about Home Equity Loan Basics
and How to Qualify
Using your home as collateral, a sizeable amount of credit may be available for you with home equity loans. The difference between the appraised (fair market) value of your home and the remaining balance on your mortgage is the equity interest you have in your home. You can borrow against this equity with Home Equity Line of Credit: "HELOC" programs or "Fixed Lump-Sum amount" Home Equity Loans.
Home equity loans are often called a "second mortgage". They are commonly used for things such as home projects, debt-consolidation, or to free up some cash for various reasons. Home equity loans and HELOC programs are usually repaid in a shorter period than a 1st mortgage. Most repayment periods are between 10 and 15 years, but can be as short as 5 years or as long as 30 years.
Home equity loans are secured by your residence, so lenders consider them almost as secure as primary mortgages. Interest rates will generally be higher than a primary mortgage, but lower than credit card rates and auto loan rates. Also, the interest on home equity loans is tax deductible, while there is no tax deduction for consumer interest. Another option is the "cash-out refinance" option. The mortgage rates on the cash-out refinance will generally be lower than fixed rate home equity loans, but the closing costs will most often be higher for the refinance. You can weigh both options to see if home equity loans are the best fit for you.
Mortgage lenders will request the same basic information as with a refinance or debt consolidation to qualify you for a home equity loan or line of credit. Income, Credit, and Equity (ICE).
Home Equity Loan: Income
Your gross monthly income is used to derive a very important ratio called the "Debt to Income" ratio. The DTI ratio is calculated by dividing your total monthly household expenses by your total monthly gross income. Your total household expenses are found by adding all monthly expenses from your credit report plus your monthly property taxes and monthly homeowner's insurance and monthly mortgage payments. The lower this ratio, the better for qualification purposes.
For example, if your total monthly household expenses amount to $2000.00 and your gross monthly income is $5000.00, then your DTI would be a .40 (2,000 divided by 5000). Generally you will need this number to be at .45 or below for most lenders to qualify for home equity loans.
W2's, tax returns, and Social Security annual award statements are some typical documents required to show proof of monthly income. Many self-employed individuals file tax returns, which are not totally reflective of their actual earnings due to normal business deductions and write-offs. An individual in this situation has the option to simply "state' their income, providing that their credit score is high enough (some lenders will allow a stated income loan with a credit score as low as 680 for home equity loans). W2 income earners typically need to have a solid two-year work history with no gaps in employment. The self-employed individual usually needs to show proof that they have been in business for at least two years in order to qualify for home equity loans.
Home Equity Loan: Credit Score
Lenders rely heavily upon credit scores to qualify home equity loans. In most cases, the "Mid" FICO credit score is used as the primary credit score. This is simply determined by using the middle FICO credit score from the three major credit reporting agencies: Experian, Trans Union, and Equifax.
Home equity loans and the HELOC programs (home equity line of credit) are secured by the home and in second position relative to the primary mortgage. This creates more risk to the mortgage lender, and therefore, a higher minimum credit score in the range of 680 is required to qualify for most home equity loans and HELOC programs.
The credit reporting agencies use complex mathematical algorithms utilizing such factors as credit mix, credit balances relative to total credit limits, missed and late payments, judgements, collections, and the age of credit accounts to determine your score. There can be a wide range in scores between the three agencies, hence, most lenders rely upon the middle score. Scores can range from 300 to 850.
Home Equity Loan: Equity
The "fair market value" of your home, minus what you owe on your existing mortgage(s) (includes 1st mortgage and 2nd home equity loans), equals the amount of equity you have in your home.
For example. your home has a fair market value of $100,000 and you owe $60,000 on your primary mortgage. You want to take out a $20,000 home equity loan.
$100,000.00 minus $60,000 results in a $40,000 initial equity interest in your home. Home equity loans and HELOC programs are quailfied on the proposed new equity interest amout. Therefore, your equity interest for qualification is $20,000 ($100,000 minus $60,000 primary mortgage minus $20,000 new home equity loan).
A common equity-based calculation called the "Loan to Value" ratio, or "LTV", is used to determine qualification for home equity loans and HELOC programs and to make adjustments to qualifying interest rates.
LTV for home equity loans is determined by dividing the sum of your primary mortgage balance and proposed new home equity loan amount by the appraised value of your home.
For instance, say your primary mortgage balance is $55,000 and you are taking out a $25,000 home equity loan. The appraised value of your home is $100,000.00. The LTV would be 80% ($55,000 + $25,000 divided by 100,000), and you would be left with a 20% equity interest in your home.
You will qualify for more home equity loans and HELOC programs at lower competitive interest rates as your LTV percentage decreases. The higher the LTV, the more risk to the lender, as you have less of an equity interest in your home. That said, there are a number of high LTV loans (up to 100% and sometimes higher) on the market that have competitive interest rates, provided that you have a good credit score and meet income requirements.
Please check out home equity "loan types" to take a look at the general types of home equity loans and HELOC programs available on today's market along with the basic qualifying factors.
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