Who is the best candidate for a home equity loan?

It’s a bountiful time for U.S. homeowners. They possess a record $11 trillion in tappable home equity or about $206,000 per mortgage-holding household. Cashing in some of that equity (outright ownership stake) with a home equity loan or home equity line of credit (HELOC) can be a tempting way to achieve big-league financial goals, be they home renovations, college tuition or just settling a mountain of debt once and for all.

However, borrowing against that record home equity is easier said than done. Just look at the rejection rates. In the third quarter of 2023, lenders denied HELOCs to more than half of the applicants — almost three times the rejection rate of conventional mortgage loans. Criteria tends to be tougher for home equity loans, too.

The truth is that meeting the minimum requirements isn’t enough to get approved for a home equity loan or HELOC. It all boils down to how risky you seem to the lender. Let’s dive into what makes a homeowner best-suited to tap into their home equity.

You have paid off much of your mortgage

Those who have made considerable progress in repaying their mortgages stand the best chance of being approved for, and benefitting from, a home equity loan. There’s no specific balance amount or numerical point in the mortgage term that makes you an ideal candidate. But you should be well along the amortization path.

Here’s why. When reviewing your application, lenders will look at all your home-based debts, including the size of your outstanding mortgage and the proposed size of the home equity loan. They pair the two to come up with a combined loan-to-value ratio (CLTV), which basically compares the total amount of loans secured by your property to its appraised value.

Lenders typically prefer a CLTV of 80 percent at the most. However, according to the latest Mortgage Bankers Association (MBA) data, the average CLTV for home equity loans and HELOCs is much lower — 58 percent and 51 percent, respectively (as of 2022). A lower CLTV ratio means your ownership stake is more substantial, outweighing the amount you still owe, making it less risky for lenders. A lower CLTV also provides a cushion if you default, as the house has more value than the loan.

In other words, if your outstanding mortgage represents the lion’s share of your home’s worth, it doesn’t leave you much to tap — regardless of your equity’s stake value on paper.

“If you’ve got a million-dollar property and an existing $800,000 mortgage, you only have $200,000 in equity,” says Jeffrey Beal, president of Real Estate Solutions, a property appraisal and consultancy firm based in New York. “You’re not going to be able to borrow very much because a lender is going to want a bigger equity cushion. What really matters is how much equity you have in the property. Then, of course, it depends on how much you want to borrow. The more equity you have, the greater your borrowing power.”

You are ‘equity rich’

So, how much equity do you have to have to borrow? Minimally, lenders usually require a 20 percent equity stake to apply for home equity loans and HELOCs (the flip side of that 80 percent CLTV). But, as we’ve seen, having just that minimal amount of equity isn’t going to yield you very much.

Mark Hamrick, senior economic analyst and Washington bureau chief for Bankrate, says homeowners in the best position to use home equity are those who have accumulated a substantial amount of it — meaning the amount of the property they own is considerably more than the amount they owe. “This typically includes people who have been in their homes for a long time and have not often refinanced,” he notes.

Again, there’s no one magic number. But you’re likely to have the most to play with if you own at least half your home outright, what the industry calls being “equity rich.” According to ICE Mortgage Technology, which analyzes property and real estate data, most U.S. markets are equity rich as home values have climbed — meaning the average borrower’s mortgage is now less than 50 percent of their home’s worth.

In fact, according to the MBA, the average combined CLTV ratio for home equity products was 54.5 percent in 2022, which translates to just over 50 percent equity.

Lenders use the CLTV ratio not only to grant you a loan, but also to decide your loan terms (as in how much to give you) and interest rates. “Some banks ‘risk-based price’ because of loan-to-value,” says Jean Chalifoux Kiely, director of consumer banking at Sunrise Banks, based in St. Paul, Minn. “If your home is worth $200,000 and you only owe $20,000, they’re going to give you a better rate for a line of credit than they would if you owed $150,000. If there’s more equity available, they are going to offer you a better rate.”

You have an excellent credit history

Home equity borrowers need to have strong credit, stronger than the average.

While home equity lenders often state minimums in the 640-80 range, in reality the median credit score of HELOC borrowers was 761 in the third quarter of 2023, according to Home Mortgage Disclosure Act data and home equity borrowers averaged 752, according to the MBA. While both are down from the scores of the last few years, they’re still more than 40 points higher than the average American’s FICO score, which is 717.

And that $11 trillion in tappable equity Americans are swimming in? “Two-thirds of that equity is held by folks with a credit score of 760 or higher,” says Andy Walden, vice president of enterprise research strategy at ICE. “This is very important from a second-lien perspective, given the more stringent requirements that come with those types of products.”

Translation for borrowers: Fuhgeddaboudit if your FICO score isn’t “very good” — at the very least. “HELOCs and home equity loans have monthly payments. Understandably, lenders want to make sure that you make enough money to be able to pay that off,” says Shoji Ueki, head of marketing and analytics at Point, a home equity investments provider. “It can be a lot to come up with enough income to pay this off, on top of paying off your mortgage and on top of paying off the basic necessities like your groceries and whatever else you have.”

Your credit score is just one part of your financial picture. Lenders also look at your credit history to see how responsible you’ve been with past debts before approving a loan secured by your home.

“When we look at a credit report, we look at their previous mortgage history payments and we’ll look at how they utilize their lines of credit,” says J.R. Younathan, vice president, state production manager, California Bank and Trust, a California-based HELOC lender. “When you look at the diversity of the type of credit that they have, do they know how to manage different types of credit? We look at their inquiries and say, ‘How many inquiries do you have on your credit? What if they’ve gotten 20 inquiries on the same product? Why isn’t anybody saying ‘yes’ to this person?”

You are financially stable

Besides having substantial equity and a good credit history, you need a reliable income, steady employment and minimal debt. Lenders measure your financial health by determining your debt-to-income ratio (DTI). DTI shows the portion of a borrower’s income that goes toward monthly debt payments, including mortgages and credit cards.

The lower the DTI, the better, as it indicates you don’t have too much debt eating up your income, and can comfortably handle your financial obligations. While many lenders cap the maximum DTI at 43, HMDA data shows the median DTI of a HELOC borrower was 40.67 in the third quarter of 2023.

“It can be a challenge for many people to meet that DTI requirement,” says Ueki. “If you have the standard W2 income, that’s one thing. You just have to make enough money, which is hard in itself. But a lot of people don’t have the standard 9-to-5 income. For them, it’s especially difficult.”

Lenders are starting to cater to borrowers with non-wage income — like the self-employed, independent contractors and small business owners — with new types of home equity loans and HELOCs. But whatever the form it takes, that income better be substantial.

According to a 2020 Consumer Financial Protection Bureau report, the median income of HELOC borrowers is approximately $107,000, almost $33,000 more than the median household income in 2022.

You borrow with a plan

Deciding whether to take out a home equity loan or a HELOC is a big decision — literally. While dollar limits vary by lender, credit lines for HELOCs can run in the hundreds of thousands. Home equity loans also tend to be substantial, with five-figure minimums. The benchmark home equity loan that Bankrate tracks, for example, is $30,000.

Before signing on the dotted line, understand how the loan is structured and devise a plan to repay your debt. HELOCs in particular tend to have variable interest rates and if rates adjust higher, repayments can become unaffordable very fast. You could end up on the wrong side of home equity loan delinquency rates, which rose in the first quarter of 2024.

Most lenders won’t ask you what you plan to use the funds for. Using your home’s value to increase its value, by doing major renovations or remodels, can be a smart move. So can using the funds to pay off high-interest credit card balances or other loans. While their rates have risen in the last year, home equity products still tend to be much less expensive than personal loans and plastic.

But, whatever your aim, don’t give in to the temptation to borrow more money than you need. “Even if you didn’t, for the purposes of underwriting, [lenders] are going to assume that the entire loan has been drawn down because you have the right to do that,” says Beal. “They’re going to look at your ability to pay down the entire loan.”

Remember, a high loan amount increases the total debt secured by your home, raising the risk of default if the borrowed amount significantly reduces your equity. Home equity loan repayments can stretch out for as much as 30 years, like mortgages, but if you can pay yours off sooner, all the better.

As for HELOCs, you can settle your outstanding balance, and then close the account or keep it open for potential use. According to Experian, about half of homeowners keep a line of credit open with a zero balance for future financing needs (at least until the draw period ends). Maintaining a zero balance can boost your credit history, including raising your credit utilization ratio, a significant factor in credit scoring.

The bottom line on getting a home equity loan

Don’t assume that you can get a home equity loan just because you jumped through all the hoops to get a mortgage. In many ways, qualifying is a lot harder. Lenders are taking a risk in loaning to you, so they set the criteria higher.

The ideal home equity borrower exceeds the minimum requirements that lenders set, including having a significant amount of equity in their home, stable and substantial income, and an excellent credit score.

“The value of the property minus any debt on the property is your equity. That’s certainly helpful,” in getting a loan, says van den Brand. “However, if you have bad credit, you cannot afford the monthly payment, or prove that you have the income…you’re still going to be denied. It’s the trifecta of those three that will determine it.”