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As you make mortgage payments and your home value increases, your share of ownership in your home — your equity — also increases. Home equity loans and home equity lines of credit, or HELOCs, are two ways to turn some of that equity into cash without having to sell your home.
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Home equity loan vs. HELOC
A home equity loan converts some of your equity into cash. You’ll receive it as one lump sum and pay it back at a fixed rate.
Alternatively, a HELOC is a line of credit that you can draw on, pay back and draw on again — also called revolving credit — for a set period of time (usually 10 years). It often starts with an adjustable interest rate and can be followed by a fixed-rate period.
How much you can borrow
“Typically banks will lend up to 80% of the value of the property,” says Jon Giles, head of consumer direct lending at TD Bank. “Many banks, including TD, will lend higher than 80%, but you typically have a higher interest rate.”
Some lenders — such as Navy Federal Credit Union — have options to borrow up to 100% of your home’s equity.
“If you’re going to go above that 80%, expect about a 1% to 2% increase in your interest rate,” Giles says.
Your lender might make you an offer based on your property value, but there's a little more math required to find out exactly how much you might receive. If your mortgage balance is $200,000 and your home is worth $325,000, and you were to borrow 80% of the home’s value, then your credit limit would be $60,000. This is because the lender would loan you 80% of the home’s $325,000 value — $260,000 — minus the $200,000 that you still owe.
How to qualify for a home equity loan or HELOC
Although home equity loans and HELOCs are different loans with their own unique terms and benefits, an applicant who qualifies for one will typically also qualify for the other, according to Ace Watanasuparp, Citizens Bank’s national director of strategic sales. “These are very, very similar guidelines, whether it’s a home equity line of credit or a stand-alone home equity loan.”
The exact requirements vary by lender. However, you’ll have the best chance of getting approved if you meet these minimum criteria.
Equity of at least 15% to 20%
When the value of your home is greater than what you owe on the mortgage, you’ve got equity. Lenders will want you to have built up at least 15% (preferably 20% or higher) equity in your home, which is determined by an appraisal.
A debt-to-income ratio below 50%
Lenders will want you to have a debt-to-income ratio of 43% to 50% at most, although some will require this to be even lower. To find your debt-to-income ratio, add up all your monthly debt payments and other financial obligations, including your mortgage, loans and leases, as well as any child support or alimony. Then divide this by your monthly income, and convert that number to a percentage. For example, your DTI is 40% if you earn $3,000 a month and make payments totaling $1,200.
A credit score over 620
“Homeowners with a credit score of at least 620 will definitely have an easier time getting approved,” says Watanasuparp. Higher is better, however, as Watanasuparp recommends a credit score of at least 720 to qualify for the best rates.
According to the credit reporting company Experian, borrowers have the best chance of qualifying for approval with a score of at least 700. If your score is lower, you should be an outstanding candidate in other areas.
A strong history of paying bills on time
A strong track record of paying your bills on time demonstrates your reliability as a borrower. Late payments stay on your credit report for seven years, and the longer a bill goes past due, the stronger its impact on your financial profile.
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Who should get a home equity loan
Since borrowers receive home equity loans as one lump sum, this is an ideal way to tap your equity if you know exactly how much you’ll need to borrow. This kind of loan can also be a good fit if you’re financing just one project or other expense, so long as you meet the lender’s minimum criteria.
“One thing with home equity is that it’s always good to use it for something that will give you a long-term return,” says Giles. For example, your home’s equity could be used to fund education expenses or home remodeling. It could also help you consolidate debt, if the loan allows you to pay down that debt faster or at a lower rate.
Who should get a HELOC
Since HELOCs are a line of credit that you can draw from as needed, they’re a more flexible option for tapping your equity. If you know that you’ll want to make ongoing withdrawals — such as for a series of projects — or if you don’t yet know exactly how much you’ll need to finance your expenses, then a HELOC could be a good fit for your needs.
There are risks that come with accessing your equity early, and consumers should use their best judgment when taking out this kind of loan. When you borrow against your home’s equity, you’re putting your house on the line as collateral, which means the bank could take the house if you don't make the loan payments on time.
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