Lending institutions consider several criteria
when someone applies for a home equity loan. These
criteria give the lender an idea of the big picture
concerning your financial health and personality.
The rules are not always hard and fast. For example,
applicant Joe Doe is shelling out half his income
for bills, but when it comes to paying on time,
he's got a stellar past. Mr. Doe could still be
a "go" for a home equity lender because
one factor balances out another.
To prepare yourself for scrutiny, here's a rundown
of what a lender looks at in prospective home
equity borrowers.
Credit history: Reports obtained through the
major credit reporting agencies tell a lender
a lot about your borrowing habits and how well
you manage your money. These reports tell how
much you owe, when you pay, and whether you've
had any bankruptcies or judgments. Bad credit
-- such as late payments, repossessions and delinquent
accounts -- remains in your credit history for
seven years. Bankruptcy remains on your record
for 10 years.
The story of your credit determines your credit
grade; it's just like being back in school. A-grade
borrowers make up about 65 percent of the home
equity market, according to the National Home
Equity Mortgage Association. The B's comprise
about 25 percent; C's are 9 percent and D's only
1 percent of the market.
If your credit grade is C or D, you may still
qualify for a loan if you have factors that would
balance out another credit blemish. But expect
a "sub-prime" or "non-conforming"
loan at a higher interest rate than the one your
squeaky clean A-grade neighbor obtained.
Source of income: Lenders know that an interruption
of income due to loss of job or illness can cause
a borrower to default on a loan. Hence, they look
at several things in relation to earnings:
1. Salary or wages from a job: Lenders want to
know how much you make and how long you've been
at your job, as well as how long you have been
working in your particular field.
2. Self-employment income: Your net earnings --
gross income minus business expenses -- and how
many years the business has been providing this
income.
3. Unearned income: The annual amount and sources
are important. Secure pensions, high-rated bonds
and other stable sources are preferred.
Debt-to-income ratio: How much of your monthly
income goes toward paying off your mortgage, credit
card bills, car payment and other obligations
-- including the payments you would have to make
on the loan for which you are applying -- determines
your debt-to-income ratio.
Of course, the lower the debt the better. Most
people are expected to have a debt-to-income ratio
of somewhere between 25 percent and 50 percent.
When you hit 45 percent or more, you're living
on the edge and a lender is going to look twice.
But if there are other factors in your favor,
such as high income, it's a judgment call on the
part of the borrower.
Loan-to-value (LTV) ratio: In short, this is
the ratio between what you owe on your house and
what it's worth.
In general, the better your credit, the higher
an LTV ratio lenders will allow you to carry
To calculate an LTV ratio, let's say you agree
to buy a home with a fair market value of $100,000.
You put down $20,000 -- or 20 percent -- of the
price as down payment. You borrow the rest --
$80,000 -- to complete the purchase. That means
your mortgage LTV ratio is 80 percent, because
your loan amount is 80 percent of the value of
the home.
How is LTV calculated for a home equity loan?
Let's say your house now has a fair market value
of $150,000, and your first mortgage has a principal
balance of $50,000. Your equity is $100,000. If
you want to borrow $40,000 against that equity,
combine that with what you owe ($50,000), and
it leaves you with a total debt of $90,000.
In this case, your combined debts of $90,000
are compared with your home's value of $150,000,
for a total LTV ratio of 60 percent.
Traditionally, LTV caps are 80 percent, but there
are lenders who will give out loans of 125 percent
loan-to-value -- which means they are letting
you borrow more than your house is worth. (See
Risks of High-LTV loans.)
What you plan to do with the loan: Although prospective
borrowers are not required to disclose why they
want an equity loan, lenders will usually ask
-- and it is one of the factors they consider
because it can help determine your ability to
repay.
For example, if you plan to use the money to
consolidate revolving credit debt, bankers see
that as a positive.
"Different lenders have different factors,"
says Steve O'Connor, senior director of residential
finance for the Mortgage Bankers Association of
America. "If they see you are using it to
improve your risk profile they know that they
are more likely to get repaid."
Documentation: Be prepared to show your lender
proofs of income, such as W-2s, tax returns and
other earnings statements. Borrowers who can't
provide all the necessary documents to back up
the numbers the lender is looking for may be denied
credit or charged a higher interest rate.
Tip: Be sure you give accurate answers about
your income, assets, debts and other information.
Penalties can be tough for borrowers who give
false information to obtain credit.
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