Banks and other finance companies use a similar underwriting process for both loans and lines of credit. In order to take out a home loan or line of credit you must have equity in your home, good credit and sufficient income to cover your monthly payment. However, due to differences in how the two products work, equity lines are often easier to qualify for than loans.
When you take out a loan, your lender disburses the loan proceeds as a lump sum. Your loan amortizes over the loan term which means that your monthly payments are arranged so that you payoff the entire balance of principal and interest owed on a specific date in the future. On a line of credit, you only have to make interest-only payments and can delay paying any principal until the line of credit term actually comes to an end. Since you do not have to pay towards principal, your payments on a line of credit are typically lower to begin with, which means that someone who lacks the income needed to qualify for a loan can offer qualify for a line of credit.
Once a loan term begins, the bank cannot require you to pay the loan off early if your home falls in value. On an equity line, your lender gives you access to a revolving credit line. Your lender cannot require you to payoff the balance of your line of credit prior to the end of your line of credit term. However, if your home value drops, your lender can reduce or close any unused portion of your line of credit which means you can no longer draw on the line.
Loan To Value
If your home's value drops and you fall into foreclosure your lender may end up taking a loss if your home sale does not generate enough money to cover your home loan debt. Consequently, lenders normally only allow you to borrow 80 or 85 percent of your home's value in the form of a home loan. Since lenders have the ability to reduce your equity line if home prices begin to fall, many lenders allow you to borrow 90 percent of your home's value in the form of an equity line. This means that equity lines are easier to qualify for than loans if you have very little equity in your home.
Equity lines have variable interest rates which means your payments can rise over time. The combination of rising interest rates and interest only payments put you at a higher risk of default than a homeowner who has a fixed-rate home loan. To mitigate the risk that equity lines pose to lenders, many lenders require equity line borrowers to have higher credit scores than equity loan borrowers. Therefore, while equity lines are generally easier to obtain, for someone with a low credit score, a loan may represent your only option.
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