The Rules on Debt and Income for a Home Equity Line of Credit

by Shauna Zamarripa ; Updated July 27, 2017
Home equity is the difference between the mortgage balance and the value of the property.

A home equity line of credit is essentially the difference between the market value of your property and the balance on the first mortgage. These loans provide homeowners a resource for consolidating debt, paying college expenses or paying for major home repairs and upgrades. While these loans come with several benefits, there are guidelines that the homeowner must meet to qualify.

Debt to Income (DTI)

There are four items a bank will review for a home loan or a home equity loan: income, debt, ability to pay for closing costs, and credit. Out of these four, the debt-to-income ratio is the primary qualifying item for a home loan.

There are two ratios: the front end ratio and the back end ratio. The front end ratio represents a percentage of a borrower's income, minus housing costs for mortgage, property taxes and insurance, whereas the back end ratio represents the percentage of total unsecured debt.

The guideline that mortgage companies follow before approving a home equity line of credit is to prove that the debt does not exceed the maximum back end ratio allowed. For example, the most common guideline for debt-to-income ratios is 33 percent income to 38 percent debt, which is written as 33/28. So a consumer with a ratio of 33 percent on the front end and 52 (33/52) percent on the back end would not qualify for a home equity line of credit until she pays down her total debt to the 38 percent mark.

Credit

The next item a bank scrutinizes in a home equity line of credit approval is a borrower's credit history, to assess the bank's risk for extending credit. Generally, the consumer should have no late payments or missed payments within a 24-month term on any other secured or unsecured debts. If the consumer missed or was late on a mortgage payment at any point, that jeopardizes a home equity line of credit approval, and can do so for up to 3 years from the date of the missed or late payment.

Appraised Value

A lender's guidelines for the appraised value of a property is the third rule to meet in receiving a home equity line of credit. The appraisal value is determined by the market value of a property less the balance of the first mortgage. As part of the home equity line of credit approval process, the borrower pays an independent and licensed appraiser to perform this service. The fee for an appraisal ranges from $300 to $800, depending on location and size of the property. Regardless of approval for the line of credit, this fee is non-refundable.

The appraisal value must show that the homeowner has a minimum of 20 percent equity in the home, at which point he is eligible to borrow that amount. For example, a consumer who owes $100,000 on a home that is appraised at $125,000 shows 25 percent equity and is eligible for a $25,000 home equity line of credit.

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