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You may need to tap your home equity for any number of reasons, such as for cash for a big remodeling project, a second home, or a child’s education. Having home equity means you could be eligible for a relatively low interest rate home equity loan.
But simply having equity isn’t enough to qualify for these loans. Lenders look for borrowers who have other criteria that make them lower risk, such a low debt-to-income (DTI) ratio. Here is what you need to know about how your DTI ratio plays a role in whether you qualify for a home equity loan.
Key Takeaways
- When you apply for a home equity loan, lenders will look at your debt-to-income (DTI) ratio as one measure of your ability to repay.
- Your debt-to-income ratio compares all of your regular monthly loan and credit card payments to your gross monthly income.
- Many lenders will want to see a DTI of less than 43%.
What Is a Home Equity Loan?
A home equity loan is secured by the equity in your primary residence. Your equity is the difference between your home’s current market value and how much you owe on it. With every mortgage payment you make, you build some equity in your home. Home improvements or a rising housing market can also increase your equity.
Once you have at least 20% equity in your home, many lenders will consider you for a home equity loan. If you’re approved, you’ll typically get payment in the form of a lump sum that you will then repay over an agreed-upon period of anywhere from five to 30 years.
Home equity interest rates, typically slightly above primary mortgage rates, are often an attractive alternative to high-interest personal loans or credit cards. The downside is that if you can’t make your loan payments, you risk losing your home.
Tip
If you have a DTI higher than 43%, lenders may not qualify you for a home equity loan. Consider applying for a home equity line of credit (HELOC) instead. This adjustable-rate home equity product tends to have more flexible requirements for borrowers.
What Is a Debt-to-Income Ratio (DTI)?
Your debt-to-income ratio (DTI) indicates the percentage of your monthly income that is committed to paying off debt. That includes debts such as credit cards, auto loans, mortgages, home equity loans, and home equity lines of credit. If you make child support payments or pay alimony, those can also count toward your DTI.
To calculate your DTI, divide your total monthly debt payments by your total gross income. For example, if your monthly debt payments total $3,000 and your gross monthly income is $6,000, your DTI is 50%
What DTI Do You Need for a Home Equity Loan?
More than anything, lenders want borrowers who can pay back their loans regularly and on time. To that end, they look for people with low DTIs because it indicates that they has sufficient income to pay for a new loan after paying their current debt obligations.
The maximum DTI that most home equity loan lenders will accept is 43%. Of course, lower DTIs are more attractive to lender because it indicates you have more room in your budget to afford a new loan. A lower DTI can make you eligible for a larger loan or a lower interest rate, or both.
To decrease your DTI, you can pay off some debts before applying for a home equity loan. Paying down your credit cards is one way to do that. Reducing your credit card balance will also lower your credit utilization ratio, which can boost your credit score, further helping you qualify for a loan.
The Consumer Financial Protection Bureau (CFPB) suggests that homeowners aim for a total DTI no higher than 36%. In terms of mortgage debt alone it suggests a DTI of no more than 28% to 35%.
Can a Good Credit Score Make up for a High DTI?
Typically, no, but this could vary by lender. However, it’s possible that a very low DTI might persuade a lender to take a chance on you if you have an unattractive credit score. Each lender will have its own ways of quantifying your creditworthiness. So, if you’re turned down by one lender, another one might still offer you a loan.
Can You Have More Than One Home Equity Product at a Time?
Yes. As long as you have enough equity to borrow against and you meet the qualifications for each product, you can have multiple home equity loans, or a home equity loan and a HELOC. To account for all your loans, prospective lenders will look at your combined loan-to-value (CLTV) ratio to determine how much more you can borrow.
Can You Pay Off a Home Equity Loan Early?
Yes, you usually can. Most home equity loans don’t have early payoff penalties, but you should check with your lender before signing your closing papers. If there is a penalty and you want to pay your loan off early, calculate whether that strategy would still save you in interest with a penalty.
The Bottom Line
When you’re thinking about getting a home equity loan, you’ll also want to consider the impact that another loan payment will have on your monthly budget. Your DTI is one metric that lenders use to predict how capable you will be to pay them back.
If you use nearly half of your income goes to paying debt, another loan payment may strain your budget. And if you can’t keep up with your mortgage or home equity loan payments—due to a job loss or other financial emergency—you could lose your home. So aim for a lower DTI, for both your qualifying creditworthiness and your own peace of mind.
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Image and article originally from www.investopedia.com. Read the original article here.