If you have owned your home for awhile, you might be considering a home equity loan. Before you start the process, you’ll want to know what’s required of you to be approved and receive a good interest rate.
What is a Home Equity Loan
A home equity loan is simply a second mortgage on your home. Most, if not all have a fixed interest rate instead of a variable interest rate. This is an advantage as you will always know what your monthly payment is and it will never change. For more on interest rates, see interest rates 101.
In addition, this type of loan has a set term. Typically, you will need to pay the loan back in ten to fifteen years.
Just keep in mind, with a home equity loan, your home will be used as collateral. That means if you can’t make your payments, your home could be in jeopardy. Consider this as one of a few sources of emergency fast.
How to Get a Home Equity Loan
There was a time that it was pretty easy to obtain this type of loan, but lending standards have tightened after the housing bubble burst in 2008.
There are three major requirements you must meet to obtain a home equity loan. They include the following:
1.) Your loan-to-value ratio – The amount of money you can borrow is determined by the difference between the value of your home and how much you still owe on your mortgage. For example, if your home is worth $300,000 and you still own $200,000, your equity is $100,000.
For most lenders, you need to have quite a bit of equity available before you can be approved, and you also need quite a bit left after you receive your loan. For many lenders, this means that you would need 15 percent of equity left after you receive your home equity loan.
It’s called a loan-to-value ratio. That simply means the difference between how much your home is worth and how much you owe on your mortgage. For most banks, the loan-to-value ratio needs to be no higher than 85%.
Some banks want this ratio to be under 80%. The reason is, they feel it will take 20% of your home’s value to recoup their money if you default on the loan.
Using the above example before you received your loan, your loan-to-value ratio would be 66 percent, so you would be able to borrow $45,000 dollars. That would leave your loan-to-value at 85 percent after your loan.
2.) Your debt to income ratio – The second thing lenders look at is your debt to income ratio. This is determined by how much you earn each month, your gross monthly income, and how much your monthly payments are.
The payments include your mortgage payment, taxes, home association dues, insurance, credit card bills, any IRS payments you may have, student loans and car loans. Basically, they add up all of the debt you currently have and determine how much you have to pay each month.
This total is then compared to your gross monthly income. They are looking for a ratio of 45 percent or less. The lower this number, the better. For example, if you make $4,000 per month and your debts are $1,500 per month, your debt to income ratio is 37.5 percent.
Lenders look at this number because they want to make sure you have enough money each month to make additional payments on a home equity loan.
If your current payments take up too much of your monthly income, you may find it difficult to make additional loan payments if you have an emergency situation. Banks don’t want you or themselves to end up in that position.
3.) Your credit score – Just because you can afford the monthly loan payments doesn’t mean a lender will approve your loan. They also want to make sure you have a good credit history.
If your credit score is between 660 and 680, you will have a good chance of being approved, but it isn’t a done deal. Some lenders are going to want a credit score of 700 or higher. But you can improve your score is a few steps, see: easy ways to an improved credit score.
In addition, it’s important to keep in mind that the higher your credit score, the lower your debt-to-income ratio, and the lower your loan-to-value ratio, the better your interest rate will be.
Using the equity you have in your home can make a lot of sense if you are planning on doing some remodeling or have some other major project planned. Just be sure you have the equity available, enough income, and the right credit score before you start the application process.
This information was brought to you by BetterLoanChoice
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