Purchasing a house at a convenient location, well built, within the price range, and being within the mortgage limits is one thing; making that house a “dream home” another.
When you buy a house, you start renovating it immediately. Alterations and modifications in the house portions continue until you see a perfect house!
That by the way never happens! All that process of alterations and changes does not only associated with costs only, it is a continuous process of value addition.
There are certain factors external and internal that turn a house into “EQUITY”. More often than not, when people apply for their first mortgage, they run out of cash.
Some other unforeseen expenses might come to agitate the homeowner too. At that stage, the homeowners look for other options of credit facilities, including refinancing, second mortgage, and Home Equity Loans.
The common notion with Home Equity Loans is that these loans are easy to avail, come cheaper, and do not affect the buyer’s credit score.
A Home Equity Loan is the one that buyer avails against the collateral of the home. Under normal circumstances, the Home Equity Loan is deemed a safe lending option by the banks and credit unions. There are two types of home equity loans which banks offer against the collateral of the home equity.
- A Home Equity Loan or the HELOAN
- A Home Equity Line of Credit or the HELOC
Both these types of loans are granted against home equity collateral but differ in characteristics. A HELOC is a revolving credit facility with a maximum amount defined, where the interest rates are variable and you pay the interest on the amount you withdraw.
A HELOAN comes with a lump sum amount agreed with and approved by the lender, charges a fixed interest rate, and has a fixed installment amount plan.
There are certain benefits and limitations for home equity loans, against other options of refinancing and second mortgages. Availing the right type of Home Equity Loan option depends on your needs and the purpose of the funds.
When people think about applying for a home equity loan, they get frustrated with the application processing delays and rejection. The common perception is that these loans are easier to avail of.
The procedure of a loan/mortgage approval is a lengthy and difficult one, which starts with documentation, verifications, and approvals. There are certain risk factors associated with loan approvals, the Home Equity Loans are no exception too.
We’ll consider a few of the risks that make it hard for a Home Equity Loan approval.
Macroeconomic Risk Factors:
This is probably the only broad risk category that is beyond the control of an individual loan buyer. When the balloon of mortgage business boom busted in 2008 and it caused the Global Financial Crunch (the GFC), it made the whole mortgage market collapse.
A recent example of a similar phenomenon is the market slump caused by the COVID-19 pandemic. If the macroeconomic situation goes through such a cycle as a whole or in particular geography the income power of the loan buyers shrinks.
The banks and the credit unions are the most risk-averse businesses (at least after 2008); in such situations, the banks will tighten the noose of lending risky loans. High rates of unemployment make both the public and the lenders at large panicky.
Even safer loans such as Home Equity loans get reconsideration. In a real-life example, US banks have upgraded the safe credit score from 660 to 720 after an increase in applications for equity loans.
Few financial institutes like Wells Fargo have even announced to halt the Home Equity Loan applications temporarily.
The Credit Score:
Perhaps the most critical factor in deciding your loan application is your credit score. Loan buyers with a constant stream of income, good credit history, and good market value of the collateral may enjoy a good credit score rating.
The case for the Home Equity Loan is a little different; it is often applied as an alternative to the second mortgage. The credit score over the years for you, after your first mortgage and any other credit card, personal, and vehicle loans will change.
Your income stream also changes the credit score and economic downfall like recent ones caused by COVID-19 also reduces the income potential. It gets harder to win a Home Equity Loan package with a bad credit score, even worse it gets expensive.
The Loan to Value (LTV):
One of the important factors the lenders consider while approving a Home Equity Loan is the loan-to Value ratio. The first mortgage payments to the lender will affect directly your “value” for the second mortgage or home equity loan.
As in most cases, if you are applying for debt consolidation purposes your LTV gets higher. The safe limit considered by lenders is 80% or lower.
Normally a Private Mortgage Insurance isn’t required for home equity loans, but if the LTV rises above the safe limits, the lender will ask for a PMI.
If you’ve been paying more on your first mortgage principal amount, there are still dangers of a risky LTV, as at the time of second mortgage or Home Equity Loan appraisal the market value of the home is reassessed.
The Debt to Income Ratio:
This is a unique phenomenon for loan buyers, where both external and individual risk factors combine to determine the credibility of the loan applicant. Your total regular income divided by your monthly debt payments is the Debt-To-Income ratio.
Banks and other lenders consider this ratio to be safe if it is below 40% for the first mortgage and around 30-35 % for the second mortgage or a Home Equity loan.
This ratio is often difficult to keep in check with credit card payments, personal loans, first mortgage payments, and any other short-term credit facility.
At the time of application, all debts against your name with different lenders are consolidated to calculate your debt-to-income ratio. If your income is affected by a bad business situation, your income stream will fall and affect your debt ratio badly.
Uncertainty in income stream:
Over time, your income stream will change, positively or negatively. At the time of application for your Home Equity Loan, the lenders will assess your income stream. If your source of income is no more reliable or regular, the lenders may not approve your loan application.
This is particularly, a painful experience for many loan buyers, as they do not consider this point when applying for refinancing, or a second mortgage option like Home Equity Loan.
For clarification, an uncertain source of income is different from an irregular income. A part-time job or an hourly wages pay structure may be a more consistent income stream than a commissioned-based non-regular income.
History of bankruptcy:
The first mortgages run for a long period depending on the agreement with your lender. Loan buyers often apply for personal loans, vehicle loans, and/or credit card facilities.
If you go through a foreclosure or a bankruptcy process during any of your mortgage terms, the lenders will mark it. For the coming years, that bankruptcy will be part of your credit history, even if you have recovered from it and settled your earlier debts. This scenario often appears with the loan buyers looking for debt consolidations.
There are certain other points that make the Home Equity Loan appraisal hard. Most of those factors relate to the documentation, lack of knowledge about filing, and loan procedures.
- Verify your credit reports before you submit them to your lender bank. Your credit history is stated in these reports; an error missing any of your payment might cause you the loan application approval.
- Complete the required documents with the loan application, hire a professional to submit your loan application. Although hiring a professional broker agent may seem costly, but a professional is worth doing a job than failing in it yourself.
- It might be a good idea to settle a small outstanding loan like a credit card before you apply for a substantial one like a Home Equity Loan. This might help reduce your total debt, to increase your chances of an appraisal.
If you are considering applying for a Home Equity Loan, be cautious about the risk factors associated with it. Prepare yourself for the hardships that you might face when your application is rejected.
In case, you are using your rental property as your home equity, the Home Equity Loan appraisal may even become harder.
The biggest risk associated with a HELOC is that if you fail to make your payments, you lose your home. Even if you’re planning to move to another place and want to sell your house, your debt will be settled immediately by the lender.
Although generally, it is supposed to be an easy-to-go option than refinancing or other forms of mortgages, the loan approval might get harder than expected with a Home Equity Loan.