Your home equity represents a powerful financial platform that can be used to help finance a variety of endeavors. Whether you need to pay down credit card bills or come up with cash for home improvements, the equity in your home can be used for these purposes. Depending upon the amount of money you have already paid on your mortgage, the size of the loan you will be able to take against your equity will vary. In order to initiate the borrowing process, you will need to work directly with your preferred lender in order to ensure that you have the appropriate paperwork completed.
You can borrow money as part of a home equity loan if your current financial credentials are accepted by a qualified lender. Generally speaking, you will be required to pay higher home equity loan interest rates in the event that your credit score is too low or your debt-to-income ratio is above the thresholds established by the lender.
The Basics of Home Equity
By definition, a home equity loan can be considered a second mortgage on your property. The money you have used to pay down your first mortgage helps increase your portion of true "ownership" of your property. For example, if you have paid 10 percent of your mortgage principal back to the lender, you effectively have 10 percent true ownership of your property. Once your mortgage payments are completed, you will be the full owner of your house.
When individuals initiate a home equity loan, they are effectively borrowing the cash equivalent of the value of their current ownership of their home. So, for example, in a situation where a property owner has paid back 25 percent of their mortgage value, they may be able to borrow up to a similar value as part of a home equity loan, which you may think of as equity money.
Essentially, the collateral for a home equity loan is the property itself. When individuals borrow funds proportional to their equity, they are acknowledging that failure to repay these funds essentially forfeits their ownership of the property in question. With that in mind, home equity loans, much like a mortgage, have serious consequences attached to them for non-payment.
Home Equity Loan Disbursements
If a borrower meets all of the home equity loan requirements established by the lender, they will then be eligible to receive the funds allotted to them based on their application. Typically, borrowers can choose to receive their funds either as a lump sum or as part of a home equity line of credit.
When a borrower chooses to receive a lump sum, they will be responsible for paying back the money transferred to them over a series of regular installments, often over the course of years. With this form of repayment, interest rates are fixed at the time of the borrowing agreement. Like all loans, interest accrues on the principal balance and is paid back in combination with the principal amount.
Home Equity Lines of Credit
The alternative to a lump sum is a home equity line of credit, often referred to as a HELOC. With a HELOC, the lender will approve a certain amount of funds for the borrower that can then be accessed at any point within a certain timeframe. The HELOC is ideal for individuals who may be using these funds for a series of expenses over an extended period rather than just a single transaction. Also, the HELOC model allows borrowers to only withdraw the exact amount of funds they need at any given time rather than amassing a lump sum that is generating interest on a monthly basis.
Unlike the lump sum paradigm, a HELOC may contain variable interest rates throughout the lifecycle of the loan. With that in mind, it is always in the best interest of borrowers to pay back the funds they have borrowed as soon as they are able in order to hedge against some degree of uncertainty.
Factors Influencing Home Equity Loans
After you approach a lender about receiving a home equity loan, a variety of factors will be considered in order to determine a.) whether or not you qualify for the loan in question and b.) the total sum of funds that you will have access to. Four key data points used to answer these questions are the amount of equity you have in your property, the current appraisal value of your property, your credit score and your debt-to-income ratio.
Generally speaking, equity is defined as the amount of money you owe on your property subtracted from its actual value. So, for example, if you currently owe $160,000 on a house appraised form $250,000, your equity is exactly $90,000.
Exploring the Loan-to-Value Ratio
Your equity factors prominently into what is known as the loan-to-value ratio, or LTV. The loan-to-value ratio is calculated by dividing your current loan balance by the appraised value of the property. So, if you have $90,000 of equity and your remaining loan balance is $160,000, you will divide $160,000 into the appraised value of the property – $250,000 – to get a loan-to-value ratio of 0.64.
This number implies that 64 percent of the house is currently in the possession of the mortgage holder and that only 33 percent is truly yours. Therefore, your equity of $90,000 represents 33 percent of the total value of the home itself.
The Combined Loan-to-Value Ratio
If you have decided to apply for a HELOC, you will likely be required to submit a combined loan-to-value ratio, or CLTV. This figure represents the amount of money you want to borrow combined with the amount you currently owe on the property, the resulting sum being divided by the appraisal value of the home.
As an example, if you are currently hoping to borrow $45,000 and owe $125,000 on a $250,000 home, your combined loan-to-value ratio would be:
(45,000 + 125,000) / 250,000 = 0.68.
This number factors prominently when lenders determine whether or not your request for a HELOC represents a financial risk. As a general rule, lenders will issue a HELOC if the combined loan-to-value ratio remains under 0.85.
Impact of Your Credit Score
Your credit score plays a significant role in determining whether or not you will be eligible for a home equity line of credit. Although credit standards have loosened somewhat in the past decade following the financial crisis of 2008, individuals hoping to secure a home equity loan should have a credit score that exceeds 700. Those with a credit score slightly below 700 may still be eligible, although they will likely be forced to pay noticeably higher interest rates on the money they receive.
If your credit score is lower than 700, you may need to think twice before taking out a home equity loan at a raised interest rate. As mentioned previously, the stakes for borrowing these funds are high, and failure to pay back these funds could result in the forfeiture of the property in question. Depending upon the interest rate and the amount borrowed, choosing to take this step may ultimately result in you making steep monthly payments for the extended future. Consequently, your personal finances could be stressed in ways that you had not anticipated.
A variety of online services are currently available that allow you to monitor your credit score and identify tools you can use to improve it quickly. Many of these services will allow you to gain full access to your credit history without resorting to a hard inquiry on your report.
Understanding Your Debt-to-Income Ratio
Your debt-to-income ratio is yet another important metric that factors prominently when evaluating your eligibility for a home equity loan. The debt-to-income ratio, or DTI, is a measure of the amount of money you currently owe as part of your property in addition to other debts that you are legally liable to honor, relative to your gross monthly income. When measuring the amount of monthly debt attached to your property, a lender will look at the principal of your mortgage, your current interest rate, home insurance premiums, existing liens and all mandatory expenses associated with any homeowners associations.
As a general rule, home equity loan lenders often prefer that applicants have a debt-to-income ratio of less than 1:2, implying that their debt obligations consume less than 50 percent of their monthly income. In the event that your debt-to-income ratio is above acceptable levels, you generally have two options available to you to help lower it: increase your monthly income or decrease your debt levels. For most individuals, decreasing debt is the only viable short-term strategy in this situation.
Again, while a disproportionately high debt-to-income ratio may not entirely disqualify you from a home equity loan, the chances are good that it will raise your interest rate considerably. With that in mind, taking the time to explore all available options and reduce this debt burden is absolutely critical.
Pursuing a Home Equity Loan
In the event that you have explored all available options and located a lender willing to accept you for a home equity loan, your next step is to complete the process. Typically, you will be required to sign a variety of contractual documents that acknowledge the specific details of the loan and the terms of repayment.
If you have gained access to a home equity loan but are as of yet unsure as to whether or not this particular form of borrowing is right for you, you should take the time needed to consult with a financial expert in order to ensure that you are making the most informed decisions possible. A home equity loan represents a significant financial move that can provide just as many benefits as it can negative outcomes. Navigating the complexities of this loan will require a high degree of financial awareness and a keen understanding of your own financial health.
As a general rule, if you are feeling uneasy about assuming the level of debt that comes with any loan, this may be a sign that your finances are not currently capable of tolerating this level of stress. With that in mind, your best strategy for reaching your financial goals may ultimately involve more closely monitoring your own expenses rather than borrowing additional funds and using your property equity as collateral. Thorough research will always help illuminate what is likely the best possible option for you and your financial situation.
Ryan Cockerham is a nationally recognized author specializing in all things business and finance. His work has served the business, nonprofit and political community. Ryan's work has been featured on PocketSense, Zacks Investment Research, SFGate Home Guides, Bloomberg, HuffPost and more.