Before credit scoring, if the people at a bank didn't know you, it was much harder to get a home equity loan -- or any kind of loan -- because the lender had no way of knowing if you were trustworthy. However, even with credit scoring, a three-digit number doesn't give lenders a full picture of your ability to repay the loan.
If a stranger asked you for a loan, you'd want to know how that person had handled their debts in the past. When you go to a bank and apply for a home equity loan, the lender wants to know the same thing, and that's where your FICO score comes in. The FICO score runs from 300 to 850, with higher scores representing a lower risk of default. The better your score, the more likely you'll be approved for a home equity loan and the lower the interest rate you'll receive.
Factors Affecting Your FICO Score
Your FICO score takes into account a lot of factors about your financial history, but it doesn't give lenders a full picture of your repayment abilities. The FICO score factors in five elements: your payment history (35 percent), the amounts you owe (30 percent), how long you've had credit (15 percent), your applications for new credit (10 percent), and the types of credit you've used (10 percent). However, your current income, age, marital status and home value don't affect your score.
Besides your FICO score, lenders want to know about your home's value and any other loans that you've taken out that use the house as collateral. Depending on the economy, some lenders might allow you to take out more than the value of your home, but many will limit your total debt to a percentage of your home's value. For example, if you have a $200,000 home and your lender will let your debt go up to 80 percent of your home's value, and you have a mortgage of $150,000 still outstanding, you could only take out a $10,000 home equity loan.
Even if you've got a great credit score and equity to spare in your home, most lenders will want you to prove that you've got the financial means to repay the loan. Lenders will often ask for tax returns from prior years or pay stubs to show that you've got the financial means to make the repayments. If you can't show a steady income, you might have to pay a higher interest rate or be denied the loan.
Mark Kennan is a writer based in the Kansas City area, specializing in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."