Do you have equity in your home and want to know how to tap into it? The good news is that it is fairly simple. The bad news is you have to qualify for it. It could be a little harder only because you likely already have the large debt of a first mortgage. Now you want to add another debt on top of it. There are willing lenders, but you must know how they verify your income to determine if you qualify.
Verifying Your Income
Do you remember when you got your first mortgage? You likely had to provide documents regarding your income. They probably included your:
- Paystubs covering the last 30 days
- 2 years of W-2s
- 2 years of tax returns (if you work for yourself or on commission)
- Contact information for your employer
You’ll do the same thing for the home equity loan. A lender must know your gross monthly income if you work for someone. If you work for yourself, the lender needs to know your net business income. We discuss both below.
Your gross monthly income is the money you make before taxes. Lenders can verify this amount with your year-to-date figures on your paystubs. They can also verify it with your W-2s. They are looking for consistency or increasing income. In other words, if your W-2 from 2 years ago showed $40,000, your W-2 from last year should show at least $40,000 if not more. If you made less this year than last, the lender will likely average your income over 12 months rather than 24 months.
If you work for yourself, the lender will evaluate your tax returns. They will look at your net business income and add back any depreciation or amortization deducted from your income. They will not add back any other expenses you deducted, though. Again, lenders look back at the last 2 years. They want to see increasing income, or at the very least, income that remains stable. If your income declined, a home equity loan may not be a possibility until your income goes back up.
Why Income Matters
You might wonder why your income matters so much on a home equity loan. You already have a first mortgage, isn’t that enough proof that you can handle the loan? While it is proof, the lender needs to make sure you are not getting in over your head. They don’t want you to take on too many debts.
There isn’t one specific guideline regarding debt ratios for home equity loans, though. Many lenders keep the loan on their own books. In other words, they create their own rules because they don’t sell the loan on the secondary market.
If we had to pick one number you should aim to stay below, though, it’s 43%. This is the maximum debt ratio any loan can have in order to meet the Ability to Repay Rules. In other words, it allows lenders to know that you can truly afford the loan. A debt ratio higher than 43% has been shown to be a high default risk.
How the Lender Determines Your Debt Ratio
The lender will look at more than your income when determining your debt ratio. They also need to know the depth of your liabilities. This includes:
- Student loans
- Car payments
- Minimum credit card payments
- First mortgage payments
The lender will take any of these liabilities that you have and add to it the amount of the home equity loan payment. If you take out a fixed home equity loan, the payment will remain the same. If, however, you take out a home equity line of credit, the lender will use the maximum payment allowed. This is because your interest rate will likely be adjustable and you’ll only pay interest during the first 10 years of the loan. During the last 20 years of the loan, you repay principal and interest. This is the figure the lender must determine if it will fit within your debt ratio.
A home equity loan is generally easier to qualify for as long as you can prove you can afford it. Provide the lender with all of the necessary documentation so you know exactly what you qualify to receive. Always make sure the lender qualifies you based on the worst-case scenario payment as well. This way you know what you can comfortably afford before taking out another loan on your home.