How Your Finances Affect Your Home Equity Loan Interest Rate

A home equity loan lets a homeowner tap into the market value of their home to borrow money for any number of reasons, from consolidating debt to funding a home improvement project.

The borrower receives the loan proceeds in one lump sum and must pay off the loan over a certain period of time, often five to 30 years. The home serves as collateral for a home equity loan, which typically comes with a fixed interest rate.

Several factors affect your ability to qualify for a home equity loan as well as the interest rate you’ll be charged for the loan. These include the amount of equity you have in your home and the health of your credit, as well as current economic conditions. Let’s learn about these factors in more detail.

How Home Equity Loans Work

A home equity loan, also known as a second mortgage, lets a homeowner take advantage of the home equity they’ve built up to borrow money for various major expenses, such as consolidating debt or paying a child’s college tuition.

Economic Factors That Affect Home Equity Loan Rates

Broader economic factors beyond a borrower’s control can also affect home equity loan rates. They include inflation, economic growth, and the condition of the housing market.

The Federal Reserve sets the benchmark federal funds rate, which affects home equity loan rates. The Fed may raise the interest rate to slow inflation or lower the interest rate to spur economic growth.

Personal Financial Factors That Affect Your Loan Rates

Your financial situation also has a significant impact on the loan rate you receive. Personal financial factors can include the following:

Home Equity

Home equity is the difference between the value of your home and the balance of your mortgage. A loan-to-value ratio (LTV) is a metric that compares the amount of your mortgage with the value of your home. Generally, a lender will want to see a LTV no higher than 80% based on your home equity. Having a loan-to-value ratio of 80% means your home equity is 20%.

So let’s say your home value is appraised at $350,000 and you still owe $200,000 on your mortgage. Your home equity would be $150,000 ($350,000 - $200,000 = $150,000). To calculate the LTV, divide the mortgage balance ($200,000) by the appraised value ($350,000) and multiply it by 100 to get an LTV of 57%. This LTV is below the typical 80% threshold, so you would be more likely to get a lower interest rate.

Credit Score

The minimum credit score needed to qualify for a home equity loan varies among lenders, with many lenders requiring a minimum required score of 620. Lenders typically look at your FICO credit score, which ranges from a low of 300 to a high of 850. A FICO score of 620 is considered “fair.”

A higher credit score tells lenders you are a lower-risk borrower. So, generally, a higher credit score results in a lower interest rate for a home equity loan, while a lower credit score leads to a higher interest rate.

Debt-to-Income Ratio

Lenders also consider your debt-to-income ratio, or DTI, when setting rates for your home equity loan. Your DTI is calculated by adding up your monthly debt payments and dividing them by your gross monthly income. Gross monthly income is the amount of money you earn before taxes and other deductions are subtracted.

Let’s say your monthly debt payments are $2,500 and your gross monthly income is $6,500. In this scenario, your DTI would be 38%:

($2,500 / $6,500) x 100 = 38%

Generally, you want to aim for a DTI of 43% or lower when getting a home equity loan, according to the U.S. Consumer Financial Protection Bureau. Therefore, 38% would fall below the government-recommended 43% cap. However, DTI requirements vary by lender.

Payment History

Payment history represents 35% of your FICO score, making it an important credit-scoring factor. FICO puts more weight on payment history because it signals how likely you are to pay your debts.

The payment history for your mortgages and other debts can either help or hurt your credit score. If you have a strong track record of making payments on time, your credit score may be higher and you may qualify for a lower interest rate. A history of late or missed debt payments may result in a weaker credit score, which would lead to a higher interest rate.

Loan Term

The payoff period for a home equity loan may affect the interest rate. Generally, a loan with a shorter term (like five years) will have a lower interest rate than a loan with a longer term (like 15 years). A longer payoff period gives a borrower more time to default on a loan, so the risk is higher for the lender.

How to Qualify for a Home Equity Loan

You can take several steps to improve your odds of qualifying for a home equity loan. Among them are:

• Raising your credit score: Increasing your credit score makes you a more attractive borrower. Some ways you can improve your credit score are by catching up on past-due debt payments, reducing balances on your credit accounts, and not applying for new credit while you’re shopping for a home equity loan.
• Fixing errors on your credit report: Inaccuracies on your credit report might drag down your credit score. Correcting these mistakes may remove negative marks.
• Increasing your income: Increasing your income can help you qualify for lower rates on your home equity loan. You might, for example, consider taking on a second job to raise your income.
• Enhancing the value of your home: Home improvements and renovations might help increase your home’s appraised value. Updating your home’s main bathroom or remodeling your kitchen are among the DIY projects that can improve your home’s value.

The Bottom Line

Some factors that affect the interest rate for a home equity loan may be out of your control, such as the current economic environment. But you can improve aspects of your finances that affect how much interest you’ll be charged for a home equity loan. These factors include the amount of home equity you have, your credit history, and your credit score.

Frequently Asked Questions (FAQs)