Can You Be Denied a Home Equity Loan?
Home equity loans are similar to other loans and mortgages. They have terms, interest rates, and key criteria lenders look to see in potential applicants. Not everyone with eligible equity in their home can get approved for a home equity loan. To get the best approval odds, it's helpful to understand the criteria lenders look for in applicants.
This article will help you understand the factors which most influence your chances for approval of a home equity loan request.
What is a Home Equity Loan?
When someone purchases a home, they start to build home equity. Home equity is the investment you've made in your home since its purchase. For instance, when someone first purchases a home, their equity is equal to whatever they've paid as a down payment.
As the buyer makes monthly payments on their mortgage loan, they start to pay their principal loan amount. The amount a homeowner has paid towards their principal and whatever they paid in their initial down payment is their equity in the property. Equity also builds if real estate increases in value which can impact the current market value of your property.
Often, homeowners want to borrow against the equity they've earned in their property. There are certain types of loans that allow this form of borrowing. Homeowners can borrow against their equity using a home equity loan or a home equity line of credit - also known as a HELOC.
If you take out a home equity loan, you're able to borrow funds up to whatever limit the lender determines. These forms of credit often have a fixed interest rate and can help homeowners fund things like home improvement projects, purchase new vehicles, or other large purchases. Home equity loans appeal to many because they often have lower interest rates compared to unsecured loans, few purchasing restrictions, and repayment flexibility.
Why Would I Be Denied a Home Equity Loan?
Similar to personal loans or mortgage loans, lenders can deny your request for home equity loans. Denial is usually the result of one of the reasons listed below:
Often, one's income is a key factor lenders consider when evaluating one's creditworthiness and the ability to repay the loan. Furthermore, lenders want to see steady income streams from their applicants. A stable income assures lenders that you'll be able to repay any credit they extend to you.
Furthermore, income is an important factor in determining your debt-to-income ratio.
High Debt to Income Ratio
Debt to income ratio (DTI) is another factor that lenders examine when determining your creditworthiness and ability to repay the loan. In general, the lower your debt to income ratio, the better.
Your DTI is calculated by adding all forms of debt you currently have and dividing it by your total monthly gross income. Your monthly income includes your base salary as well as other verifiable income sources like commissions, bonuses, and rental income.
Notice that a high DTI shows a lender that your current debt is larger than your income potential. For instance, if you have $30,000 in monthly debt obligations and your full income stream is $100,000, your DTI would be 30%. Compare this to someone with $75,000 of monthly debt obligations and an income stream of $100,000. Their DTI would be 75%.
DTI is a quick calculation lenders use to determine your current credit load. If someone already has a high DTI, they may not be able to handle the responsibility of more debt. In contrast, someone with a lower DTI may be able to take more debt. As a general rule of thumb, most mortgage lenders are looking for a debt-to-income ratio of 40% or less.
Low Credit Score
Similar to other loans, credit scores are a core factor determining someone's creditworthiness. A credit score will help lenders understand how much credit you've taken on in the past and how well you've handled that credit.
Consider ordering a credit report if you don't know where your credit score lands right now. The three major credit bureaus (Equifax, Experian, and TransUnion) offer free online credit reports. If you order a credit report, you'll know if you meet the minimum credit score requirements lenders set for home equity loans.
In general, lenders want you to have a credit score in the mid-600s or higher. However, credit scores below this range can still be approved for home equity loans. You risk higher interest rates, lower loan amounts, and shorter loan terms if you have a lower credit score.
If you think your credit score will harm your chances of getting favorable terms on your home equity loan, consider taking time to improve your credit score before applying for a home equity loan or a HELOC. Some quick tips you can use to increase your credit score are paying off as much debt as possible, staying on top of your monthly payments, and avoiding applying for new credit.
Low Equity in Home
As you continue to pay off your mortgage, you'll increase your equity in your home. Your equity is the amount you currently owe on your home compared to the current market value of your home.
Lenders usually want you to have at least 15 to 20 percent of the equity in your home before qualifying for a home equity loan. Lenders use a calculation called a loan-to-value ratio (LTV) as one of the qualifications to determine if someone qualifies for a home equity loan.
A LTV is calculated by dividing your current loan balance by the current market value of your home. For example, if you have a current loan balance of $250,000 and your home is valued at $400,000, your LTV would be $250,000 / $400,000, which equals a LTV of 63%. Given this example, the total amount of equity you would have in this home would be $150,000. However, keep in mind that lenders will have requirements for the maximum LTV for home equity loans so you would not be able to borrow the full $150,000.
Your current equity will determine how much you can borrow through a home equity loan. However, lenders may deny your loan application if your current equity is too low. You would need to see the maximum LTV allowed by the lender to determine how much you can borrow for a home equity loan. Using the example above, the LTV of the first mortgage loan to the current market value is 65%. If the lender allows a combined LTV of 80% for a home equity loan (first mortgage balance plus the new home equity loan), the maximum loan amount would be $70,000 ($400,000 x .80 = $320,000 less $250,000 for the first mortgage balance = $70,000). However, this is the maximum amount you can borrow at an 80% LTV, but you would still need to qualify for that amount, as LTV is only one factor used in approving home equity loans.
If your equity is below the maximum LTV allowed by the lender, consider aggressively paying down your mortgage balance and/or making home improvements that may increase the market value of your home. Both of these will increase the equity you have in your home.
Past Credit Failures
When lenders evaluate you as a potential client, they want to see if you have a reliable history with credit. Whether you've taken out a car loan, a personal loan, or other loan types, lenders want to see an applicant who has reliably handled their past lines of credit.
Lenders will generally examine someone's payment history to determine if they're creditworthy. An excellent way to stand out to lenders is by making consistent credit card payments, mortgage payments, and other loan payments. Proving that you've been responsible with past loans and lines of credit will help you secure future loans and lines of credit. Furthermore, it will help lower interest rates on future mortgages, credit cards, and other loan types because you will have a proven track record and a good credit score.
If you've had a significant credit failure in the past, don't let that prevent you from becoming a good steward of your current loans and lines of credit. Credit scores can bounce back if you continue to make consistent timely payments. Try not to take out loans or lines of credit beyond your means. Often people can become overwhelmed by debt if they're not careful and severely impact their credit score and ability to get new loans or the best rates on new loans.
What Do I Do If I Was Denied a Home Equity Loan?
It's okay if you were denied a home equity loan. You can employ different strategies to increase your odds of getting approved for future loan applications. However, before moving forward with any of these strategies, speak with your lender to determine why your application was denied. Your lender may offer additional insight over the notice of denial reasons that you will receive from the lender. That information will help you know how to best strategize a potential solution.
There are some general strategies almost anyone can benefit from. Some strategies can be done quickly, others take longer to implement.
Short Term Solutions
If possible, make a large down payment when you purchase a home. Furthermore, a sizable down payment will decrease your monthly payments and decrease your DTI.
Lastly, consider getting a co-signer on your loan. This option is helpful for individuals with low credit scores. Using a co-signer enables their credit and income to be used in potential loan approval calculations. This strategy may increase your odds of approval. However, make sure you find a co-signer with a high income or good credit. A co-signer without these features may not increase your odds of acceptance.
Long Term Solutions
A good long-term strategy to help increase your approval odds for most loan types is securing a higher gross income. The higher your income, the lower your DTI ratio. Remember, a higher income doesn't have to come through a single source. Simply getting a side gig will help boost your total gross income.
Another strategy that'll boost your approval odds is to pay down your current debt. The higher your monthly debt obligations, the higher your DTI ratio. Remember, a lower DTI helps secure better loan opportunities. So, if you're able, try to pay down your current loans and lines of credit. These payments will help lower your total debt, thus reducing your DTI ratio.
Lastly, try to increase your credit score! Often this is much easier said than done. Still, working towards a higher credit score is a great way to boost your approval odds in most loan applications. Try to stay on top of your monthly payments and look into different strategies to increase your credit score.
Can I Qualify for a Home Equity Loan with Bad Credit?
Some lenders provide home equity loans to people with lower credit scores. Furthermore, some set minimum credit scores, while others don't.
Risks of Applying with Bad Credit
There are lenders who will work with people who have poor credit. However, these lenders may only offer loans with higher interest rates and loan terms. Consider employing strategies to increase your credit before agreeing to less favorable loan terms.
Lastly, if you choose to take out a home equity loan and cannot repay it, you risk losing your home. This risk is severe and worth weighing before moving forward with this loan type.
Alternatives to a Home Equity Loan
Since the stakes are high if you cannot repay a home equity loan, consider other loan types. For instance, you can always apply for a personal loan which is an unsecured loan. Personal loan rates vary, but unlike a home equity loan, defaulting on them won't cost you your home.
Depending on the amount of money you need, you may also consider applying for a credit card with a credit line amount that will suit your needs. Keep in mind that this also may include a higher interest rate than a home equity loan.
Home equity loans may be a great loan option for those who seek to borrow against the equity in their home. Not everyone qualifies for these loan types, so consider your credit score, DTI ratio, and total home equity before applying.
If this loan type may be challenging for you to repay, consider other credit opportunities. Defaulting on a home equity loan could cost you your home. So, examine different loan types before moving forward with a home equity loan.
Disclaimer: At present, Wesley Mortgage does not offer Home Equity Loans. We are providing this information to keep you informed of your loan options.