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HelpThe quality that home equity lenders look for in borrowers is termed ‘creditworthiness’. This is a combination of three things: credit history, income, and loan-to-value ratio.
Credit History
Lenders can look up your credit history at any time by going to one of the credit bureaus. These are companies that gather and collect information on the amount of debt a borrower owes and whether the borrower pays his bills on time. This information is summarized in a credit report, which condenses a borrower’s credit history into a numerical score. This score is then calibrated by referencing a scale from 300 to 850. The score is occasionally referred to as a FICO score, after the company that pioneered credit scoring, Fair Isaac Corporation.
Income
What home equity lenders look for in terms of income can be divided into three categories: how much the borrower earns, how long the borrower has had a job, and how long the borrower has been working in his or her field. They also look at your debt-to-income ratio, which is the measure of how much of your monthly income goes towards paying down debts. Those debts can be any kind of debt, from credit card debt to school loans. Always keep copies of all documentation such as W-2s and other financial statements. Be prepared to show those to lenders or they will likely turn your application down. (Or give you a higher interest rate.)
Loan-to-Value Ratio (LTV)
Finally, lenders look at a borrower’s loan-to-value ratio. This is the ratio of how much you owe on your house versus how much it is worth. For example, say your home is worth $500,000. If you have a mortgage on it worth $300,000, your loan-to-value ratio is 60%. $300,000 is 60% of $500,000. When you first bought your home, calculating the LTV ratio was simpler: all the lender had to do was take the value of the mortgage and divide it by the price of the home.
Calculating the LTV ratio is more complex with a home equity loan. This is because the home’s value has likely changed since you bought it. Home prices fluctuate up or down with market forces. When the lender considers your home as a potential asset and/or risk, the lender receives an estimate of the home’s current fair market value. This is the price of the home under normal market conditions. Then the lender adds the current mortgage balance to the size of the loan or line of credit you applied for. Finally, the lender divides that amount by the home’s current fair market value. The result is the new loan-to-value ratio.
For an example, let’s go back to the $500,000 home mentioned earlier. Lenders usually want the LTV ratio at 80% or less. So if that house owes $300,000 and its current fair market value is still $500,000, you could get a home equity loan of up to $100,000. That would put your total home debt at $400,000, or 80% of the home’s current fair market value.
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