Why and how to obtain home equity loans and HELOCs
People have many different reasons for wanting home equity loans and home equity lines of credit (HELOCs). In fact, there are some very sound financial goals that are well served by tapping into the equity of your property. There are also some not-so-good reasons. Additionally, homeowners should know the common requirements that lenders set for offering attractive HELOC and home equity loan interest rates, longish payback periods and more.
Common Criteria Set by Lenders
Every lender is a little different, but in general they usually want homeowners to meet at least four distinct criteria in order to apply for a home equity loan or HELOC:
- A debt-to-equity ratio of approximately 42 percent. Some lenders will go as high as 50 percent on this point but rarely higher than that
- Clear history of regular, on-time bill payment
- Credit score in the range above 620 in most cases
- Equity in your home of approximately 20 percent, as determined by a third-party appraisal at the time of the loan application
Remember that as the economy changes and the real estate market grows, lenders often soften or harden the above requirements for issuing HELOCs or the more traditional home equity loans.
Making the Right Choices with the Loan Proceeds
In order to get the most out of your hard-earned years of paying down the mortgage balance while the value improves, it’s best to put your loan proceeds to good use instead of going on a shopping spree on unnecessary purchases.
- To pay off or consolidate high-interest credit card debt. Even though a second mortgage or a HELOC might come with a higher interest rate than your original mortgage did, it's usually a good idea to pay off double-digit-interest credit cards with home equity cash. Homeowners can save a lot by getting rid of large credit card bills. Paying off a low-interest auto loan might not be in your best interest if you're merely swapping out one low-interest rate for another. Always view debt consolidations and non-home loan payoffs from an interest rate perspective.
- To improve your home and increase its value. Try to stick to conventional upgrades like kitchen improvements, siding and commonsense upgrades to the home's energy efficiency. Avoid improvements that fall into the "luxury" category like tennis courts, pools and extravagant kitchens or media rooms.
- To pay for emergencies. This category gets a lot of people in trouble because it's pretty subjective. Large, unexpected medical bills or expenses associated with the loss of a major job count as worthwhile expenses to fund with a home equity loan. Vacations, new cars or weddings are typically considered in the "not so smart" category and really don't even meet the bare-bones definition of "emergency" anyway.
- To purchase an "investment" property. Here's another one where people often go astray. It's considered a good rule to not borrow more than 80 percent of your home's value, even when a stellar investment property appears in your sights. Plus, make sure that the new property's rental income is sufficient to pay for the monthly home equity loan payment as well as the rental property's mortgage payment. If you stay within those parameters, the rental opportunity is likely a good reason for borrowing against your home's equity.