Home equity loans make a responsible comeback
During the heyday of home equity loans, some homeowners used their home equity like an ATM to pay for expensive vacations, boats or other luxury items. Today, borrowers are more likely to use a home equity loan for home improvements, college tuition or a major purchase such as a car, says Don McClintic, senior vice president of home equity and direct lending for SunTrust Bank in Richmond, Va.
"Borrower surveys show that home equity loans now are more likely to be used for a specific purpose rather than a lifestyle change," says McClintic. "We're also seeing home equity lines of credit used more often for an emergency fund to be prepared for a roof repair or unexpected medical bills. This is definitely more of a back-to-basics loan than borrowing for a vacation."
Brad Blackwell, executive vice president and portfolio business manager for Wells Fargo Home Mortgage in San Francisco, Calif., says Wells Fargo has been approving more home equity loans recently in comparison to the past four years, although not nearly the volume seen at the height of the housing boom. He says homeowners are being more responsible today and using their home equity to improve their home value or to pay for educational expenses.
"Home equity loans never went away entirely, but over the course of the past few years homeowners experienced a loss of equity and also became wary of taking on extra debt," says Blackwell. "The trend is changing a little bit now that prices are going up and stabilizing in some areas."
Home equity loans and debt consolidation
In the past, when home equity loans were easier to qualify for, many homeowners used them to pay off credit card debt since the interest rates on home equity loans are much lower. McClintic says the interest may also be tax deductible. "Borrowers have to specify to the lender that they want to consolidate their debt as part of the home equity loan transaction so that the debts are paid and to avoid having the credit card payments considered as part of their debt-to-income ratio."
However, since debt-to-income ratios and credit score guidelines have tightened in recent years, not all borrowers will be able to qualify for a home equity loan to pay off their debt.
"In the past, some borrowers used a home equity loan to consolidate debt and then charged their credit cards to the maximum limit again," says Blackwell. "If a borrower has a long track record of carrying high levels of credit card debt, the credit card payments may still be included in the debt-to-income ratio when qualifying for the home equity loan. We need to make sure they can handle all the payments if they run up their debt again."
Furthermore, the foreclosure crisis has made consumers more aware of the dangers of adding to their mortgage debt. Many decided for themselves to explore other options to reduce their debt level.
Home equity loan qualifications
Blackwell says that borrowers should expect their home equity loan application to be similar to a first mortgage application in terms of documentation and proof of the ability to repay the loan.
"Five years ago you may have only had to supply a pay stub, but today lenders must verify everything for a home equity loan," says Blackwell. "The process typically takes 30 to 45 days compared to a week or two a few years ago."
Unlike a few years ago when homeowners could borrow up to 100 percent of their home value, lenders today usually loan a maximum loan-to-value on both the first and second mortgages of 80 to 85 percent, says McClintic.
"The amount homeowners can borrow varies according to the housing market, so in distressed housing markets the maximum loan-to-value could be lower than 80 percent," he says.
In addition to sufficient home equity, homeowners will need a good credit score and an acceptable debt-to-income ratio. Blackwell says 700 to 720 is often the lowest acceptable credit score for a home equity loan.
"Someone with a lower credit score might be approved if they have plenty of income and home equity and a reason for a lower score such as an explainable event rather than multiple financial issues," says Blackwell.
The maximum debt-to-income ratio can go as high as 45 percent, but often this will be lower depending on the borrower's history and the lender's standards.
Home equity loan costs
Interest rates are slightly higher for a home equity loan than a first mortgage, says Blackwell. "Closing costs are usually built into the loan for a home equity loan," he adds.
While you may be inclined to approach your current mortgage lender for a home equity loan, you should shop around, says Blackwell. Shopping around for a home equity loan allows you to compare interest rates and closing costs.