If you’re considering a round of home renovations or improvements, you might be wondering if you can qualify for a home equity line of credit, or HELOC. For some homeowners, a line of credit can be the best way to get the money they need for repairs.
At Addition Financial, we get a lot of inquiries from homeowners who want to understand the home equity line of credit requirements. Before they go through the trouble of applying, they want to have a clear idea of whether a HELOC is right for them.
With that in mind, in this post we’ll explain the basic qualifications and requirements for a home equity line of credit and give you some tips about how to improve your chances of being approved.
#1: Home Equity
As its name suggests, the primary requirement for a home equity line of credit is equity, which is the difference between the value of your home and the balance you owe on your mortgage. That’s because the equity you have in your home acts as the collateral.
A good rule of thumb is you will need to have home equity equal to at least 20% of the home’s value. The value is determined by an appraisal that will be ordered by your bank or credit union.
#2: Debt-to-Income Ratio
The next factor that determines whether you’ll qualify for a home equity line of credit is your debt-to-income ratio. This ratio compares the amount of your total recurring monthly debt to your gross monthly income. For example, let's say John's monthly income is $4,700 (before taxes or other deductions). He pays $1,000 for his mortgage each month, plus $400 for his car loan and $600 for his credit cards and student loan payments. John's debt-to-income ratio is $2,000 divided by $4,700 or roughly 43%.
As you might expect, the lower your debt-to-income ratio is, the more likely you will be to qualify for a home equity line of credit. Potential lenders will want to know you can handle the payments on the home equity line of credit.
The guideline to use here is your debt-to-income ratio should be no higher than 43%. There are some lenders who may approve homeowners for a home equity line of credit with a debt-to-income ratio of as much as 50%. However, that’s not the standard.
Before you apply for a HELOC, it’s a good idea to calculate your debt-to-income ratio. If it’s too high, you can work to pay down some of your debt before you apply.
#3: Credit Score
Your credit score, or FICO score, is another key determining factor in your approval for a home equity line of credit.
So, what exactly is a FICO score? The Fair Isaac Corporation developed the FICO score to help lenders assess an applicant's past use of credit when deciding whether or not to approve an application for credit.
In general, a score of 660 or above indicates a good record of credit use. 660 is a good (but not excellent) score. Many lenders seek a score of 660 or above for any type of real estate loan.
Remember, your FICO score is determined using these criteria:
35% of your score comes from your payment history. People who pay on time will have higher scores than those who have had multiple late payments.
30% of your score comes from your credit balance. That includes your overall balance, meaning the total amount you owe. It also includes your outstanding balance as a percentage of your available credit limit. If you’re using most of the credit available to you, your score will be lower than it would be if you were using only a small percentage.
15% of your score comes from the age of your credit. People with a long credit history will usually have higher FICO scores than those with a short credit history.
10% of your score comes from the kinds of credit you have. Most creditors prefer to see a mix of revolving credit (credit cards) and installment credit (mortgages and car loans.)
10% of your score comes from the number of inquiries on your account. Any time you apply for a new credit card or loan, the lender orders a credit report. As a result, your score may be impacted slightly by a few points. If you apply for several credit lines in a short period of time, your score can be more seriously affected.
It’s a good idea to obtain your credit report from the three main credit bureaus and check your scores before you apply for a HELOC. That way, you can correct mistakes and do what you can to improve your score before you approach a lender.
#4: A Solid Payment History
Your FICO score is important, but lenders will pay special attention to your payment history. They want to know you can be relied upon to pay your bills responsibly.
Remember, the payments on a HELOC will vary depending on how much money you borrow. A HELOC acts as a revolving line of credit, so lenders will look at how you manage credit cards and other forms of revolving credit to get an idea of how you’ll manage your HELOC.
If you meet the four basic requirements outlined here, then you may be able to qualify for a home equity line of credit. A HELOC can be the ideal way to make home improvements and ultimately, increase the market value of your home.
To learn about Addition Financial’s refinancing and mortgage options, please click here now.