Requirements for a Home Equity Loan (2024 Guide) (2024)

Requirements for a Home Equity Loan

A home equity loan, often called a second mortgage, allows you to borrow against the equity you’ve built up in your home. Equity is the difference between the current market value of your home and the outstanding balance on your mortgage.

Below is a list of several standard criteria used to determine one’s eligibility for a home equity loan. These requirements ensure that both you and the lender are entering into a responsible financial arrangement.

1. Minimum Home Equity

While specific requirements may vary among lenders, most prefer you to have enough equity, typically a minimum of 20%, in your home before applying for a home equity loan, according to the Federal Trade Commission.

You can estimate your home’s current market value by contacting a real estate agent or reviewing recent comparable sales in your area. After determining your home’s appraised value, subtract the remaining balance on your current mortgage from your home’s market value. The result is your home’s equity.

To get approved for a home equity loan, you’ll likely need a professional appraisal to determine the actual equity you’ve built in your home.

This equity also limits how much you can borrow. Lenders generally want to leave you with 15% to 20% equity in the home after your new home equity loan is factored in.

2. Credit Score

Credit scores provide lenders with an indication of your creditworthiness, helping them assess the risk of lending to you. For home equity loans, your credit score is a significant determining factor in whether you’ll be approved and the terms you’ll receive.

Most lenders prefer you to have a good to excellent credit score, typically ranging from 700 to 749 or higher, according to credit rating agency Experian. Credit scores in the 700s are more likely to secure competitive interest rates and favorable loan terms. You may still qualify if your score falls between 620 and 699, which is considered fair. Still, your options may be limited, and you might face higher interest rates.

For those with credit scores below 620, obtaining a home equity loan from traditional lenders can be challenging. However, specialized lenders or credit unions may consider applicants with lower scores, though less favorable terms and higher interest rates may apply.

Credit Score Factors

Several critical factors determine your credit score, including your repayment history, credit utilization, the length of your credit history, applications for new credit accounts and how diverse your mix of credit is. The most influential factor is your repayment history, with timely monthly payments boosting it and late payments or defaults hurting it.

3. Debt-to-Income Ratio

When considering a home equity loan, it’s not just about your home’s value and credit score. Lenders also closely examine your debt-to-income ratio (DTI) to determine your eligibility. Your DTI ratio assesses the percentage of your monthly income allocated to debt payments, enabling lenders to evaluate your capacity for handling additional loan payments.

To calculate your DTI, add up all your recurring monthly debts, such as mortgage payments, credit card minimums, student loans and auto loans, and then determine your monthly income from various sources like your job, rental income and investments. Your DTI ratio is expressed as a percentage by dividing your debts by income and multiplying the result by 100.

4. Income History

Lenders typically look for a stable employment history when evaluating your eligibility for a home equity loan. While specific requirements can vary, many lenders prefer you have been at your current job for at least two years.

It’s essential to be thorough and organized when documenting your income, as this information is critical in the loan approval process. Be prepared to provide clear and accurate records to support your application.

How to Prove Stable Income

In addition to the length of time you’ve been employed at your current job, lenders also assess the stability of your income history. They want to see that your income has been consistent and reliable. Frequent job changes or gaps in employment can raise concerns for lenders, potentially impacting your approval chances.

To demonstrate your income to lenders, you’ll need to provide documentation that shows you have the financial means to repay the loan, including your pay stubs, tax returns, bank statements, employment verification and other sources of income.

>> Related: Learn more about the best home equity loan rates

Getting Preapproved for a Home Equity Loan

During the preapproval process, a loan officer will assess your financial information, covering aspects such as your credit score, income, employment history and existing debts.

Through this evaluation, you gain insights into your eligibility for a home equity loan, including factors like your credit score, income and current home equity value. Preapproval also yields an estimate of the maximum loan amount you may qualify for based on your financial situation and lender guidelines.

Additionally, while it’s not a guaranteed rate, preapprovals provide an estimate of the interest rate you might receive, enabling you to better plan for your loan payments. If your preapproval terms are less favorable than desired, the loan officer may be able to offer guidance on strengthening your financial profile to enhance your approval prospects or secure more favorable terms.

>> Related: What is a home equity loan?

How to Improve Your Home Equity Loan Approval

• Credit Score: To increase your approval chances and secure better loan terms, consider improving your credit score, as it significantly impacts your eligibility. Check your credit report from three major credit bureaus — Equifax, Experian and TransUnion — to identify and dispute errors.
  • Consistently paying bills on time, reducing credit card balances to stay below 30% of your credit limit and limiting new credit inquiries are all effective methods to boost your credit score.

• Increase Home Equity: You can also improve your eligibility for a home equity loan by increasing your home equity. One way to achieve this is by making extra mortgage payments to reduce your principal faster, thus raising your equity.
  • Additionally, undertaking renovations and home improvements that enhance your property’s value can effectively boost your equity, with a focus on projects that offer a strong return on investment. Over time, market appreciation may naturally increase your home’s value, contributing to higher equity without requiring additional effort. In both cases, you’ll need a new home appraisal for your lender to factor in the higher value.

• Provide Sufficient Documentation: Lenders want to see a reliable and steady source of income when considering your application. This documentation includes tax returns from the past two years to demonstrate your income history and financial stability. Recent pay stubs verifying your current income, including any bonuses or commissions, are also helpful during the preapproval process.
  • Potential lenders may contact your employer to verify your employment status and salary, so ensure that your employer can confirm these details. If you receive income from sources like rental income, alimony or investments, provide supporting documentation to bolster your application and increase your chances of loan approval.

>> Related: Learn more about the best ways to tap your home equity

The Bottom Line

Accessing your home’s equity can be a pivotal financial move if you have a specific use for that equity. To meet the essential qualifications, you must have a substantial amount of equity in your home, a fair credit score, a reasonable DTI ratio and reliable income.

By understanding these qualifications and following the steps to improve your financial profile, you can likely increase your odds of approval and favorable loan terms while aligning your home equity loan with your financial goals.

Editor’s Note: Before making significant financial decisions, consider reviewing your options with someoneyou trust, such as a financial adviser, credit counselor or financial professional, since every person’s situation and needs are different.