The debt ratio you need for a home equity loan

You may need to tap into the equity in your home for a number of reasons, such as money for a big renovation project, a second home, or a child’s education. The equity in your property means you may qualify for a relatively low interest rate home equity loan.

But simply having equity is not enough to qualify for these loans. Lenders look for borrowers who have other criteria that make them less risky, such as a low debt-to-income ratio (DTI). Here’s what you need to know about how your DTI ratio plays a role in your eligibility for a home equity loan.

Key points to remember

  • When you apply for a home equity loan, lenders will consider your debt-to-income ratio (DTI) as a 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 below 43%.

What is a home equity loan?

A home equity loan is secured by the equity in your principal residence. Your equity is the difference between the current market value of your home and the amount you owe on it. With every mortgage payment you make, you increase the 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 are approved, you will usually receive a payment in the form of a lump sum which you will then repay over an agreed period ranging from five to 30 years.

Home equity interest rates, usually slightly higher than primary mortgage rates, are often an attractive alternative to high-interest personal loans or credit cards. The downside is that if you can’t repay your loan, you risk losing your home.

Point

If you have a DTI above 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) shows the percentage of your monthly income spent on paying down debt. This includes debts such as credit cards, car loans, mortgages, home equity loans and home equity lines of credit. If you make child support payments or pay alimony, these may also be included in 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 repay their loans regularly and on time. To this end, they look for people with a low DTI, as this indicates that they have enough income to pay a new loan after paying off their current debts.

The maximum DTI that most home equity lenders will accept is 43%. Of course, lower DTIs are more attractive to the lender because it indicates that you have more room in your budget to afford a new loan. A lower DTI may make you eligible for a larger loan or a lower interest rate, or both.

To lower your DTI, you can pay off some debts before applying for a home equity loan. Paying off your credit cards is one way to do this. Reducing your credit card balance will also reduce your credit utilization rate, which can increase your credit score, helping you qualify for a loan.

The Consumer Financial Protection Bureau (CFPB) suggests owners aim for a total DTI of no more than 36%. In terms of mortgage debt alone, this suggests a DTI of no more than 28% to 35%.

Can a good credit score offset a high DTI?

Typically not, but this may vary by lender. However, it is possible that a very low DTI will persuade a lender to take your chance if you have an unattractive credit score. Each lender will have their own ways of quantifying your creditworthiness. Thus, if you are refused by a lender, another can 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 and meet the requirements for each product, you can have multiple home equity loans, or one home equity loan and one HELOC. To account for all of your loans, potential lenders will look at your combined loan-to-value ratio (CLTV) to determine how much more you can borrow.

Can you pay off a home equity loan sooner?

Yes, you usually can. Most home equity loans don’t have prepayment penalties, but you should check with your lender before signing your closing documents. If there is a penalty and you want to pay off your loan early, consider whether this strategy would still save you interest with a penalty.

The essential

When considering getting a home equity loan, you’ll also want to consider the impact another loan payment will have on your monthly budget. Your DTI is a metric that lenders use to predict how well you’ll be able to repay them.

If you’re using nearly half of your income to pay off debt, another loan payment can strain your budget. And if you can’t meet your mortgage or home equity loan payments, due to job loss or other financial emergency, you could lose your home. So aim for a lower DTI, both for your qualifying creditworthiness and for your own peace of mind.

Sallie R. Loera