How much home equity debt is too much? The answer depends on how much you owe to other creditors, whether you get a home equity loan or a line of credit, what you're using the money for and whether you have self-discipline.
As rates continue to rise, more and more homeowners
will ask themselves how much they can safely borrow with a second
mortgage. That's a change from the height of the refinancing boom,
when many homeowners refinanced their first mortgages for more than
their loan balances and took out the difference in cash. The heyday
of cash-out refinancing has passed because rates have risen. Now,
more homeowners are using second mortgages -- home equity loans
and lines of credit -- to extract cash from their homes.
The lender is your first line of defense against taking out a loan for too much. A reputable lender underwrites loans based on your ability to pay. "From a credit risk and business standpoint, the business thinks you can afford it," says Anthony Hsieh, president of HomeLoanCenter.com. "Otherwise, they wouldn't approve it for you."
Debt-to-income ratio crucial
A lender determines whether you can afford the loan by comparing
your debt to your income. Most lender guidelines limit borrowers
to total debt payments not to exceed 45 percent to 50 percent of
before-tax income, says Raymond Michaud, who runs Mortgage Center
of America in Trumbull, Conn.
An example: Let's say you earn $850 a week before taxes, or about $3,400 a month -- roughly the nation's median household income. Your lender doesn't want the monthly minimum payments on all your debt -- mortgage, equity loan, auto loan, credit cards, student loan -- to exceed 45 percent to 50 percent of that pre-tax income. So, when figuring out your maximum loan amount, it would seek to cap your total monthly debt payments at $1,530 to $1,700. At the higher end, you're really squeezing your monthly budget.
Here's where another calculation enters the picture: the loan-to-value ratio. Generally, guidelines limit mortgage debt to 95 percent of a home's value. So if you have a house worth $100,000 and you owe $75,000 on your first mortgage, most lenders would cap your equity loan amount to $20,000.
On top of all this math, there's another ratio to think about: the size of the second mortgage compared to the first mortgage.
Generally, the second mortgage shouldn't be for more than 30 percent of the first mortgage. So, if you're first mortgage is for $100,000, it's best to limit the amount of the home equity loan or line of credit to $30,000.
It's more than math
None of these rules are hard and fast. A bank might lend you 100
percent of the value of the house if you have good credit and you
hold almost no other debt. If you have a poor credit history, a
reputable lender will deal with you more conservatively, perhaps
limiting your total debt payments to 40 percent of your income or
lending up to 90 percent of the value of the house.
Another factor is the type of debt you take on. A home equity loan is a lump-sum amount. You start accumulating interest the moment you sign the loan papers. Your monthly payments repay the loan over a set period. An equity line of credit behaves more like a credit card. You don't pay interest until you draw from the credit line. This means that you can get a home equity line of credit, or HELOC, and not use it for months or years. After you use it, you usually are required to pay only the month's interest.
These differences mean that a home equity loan is better used to repay a one-time expense: consolidation of debt such as credit cards and auto loans, or start-up money for a business. A line of credit is better for continuing expenses, such as a lengthy home renovation, or tuition, or as a source of income in case of unemployment.
The discipline factor
"When people open up a line of credit and don't have it earmarked,
that's when they get into trouble," Michaud says. "Just
because they offer it to you, you don't need to take it."
Hsieh says homeowners frequently use lines of credit to consolidate debt. That's OK, he says, if they continue to make the same monthly payments that they were making before. They'll pay off the debt faster that way because the interest rate is probably lower.
A line of credit "is a giant credit card that you can use to sort of manage your life," Hsieh says. "But it goes back to that one word -- discipline."
If you use a line of credit to pay off your credit cards, you can't afford to run up those credit cards again.
Kelly Rote, spokeswoman for Money Management International, which runs consumer credit counseling offices in 10 states, says the agency cautions clients not to use equity loans for debt consolidation "unless the borrower has made a commitment to changing spending behavior and has made a solid payoff plan."
Michaud delivers a final caveat: "Do understand that the loans, the lines of credit, are mortgages," he says. "People forget it all the time. It's a mortgage. It's a lien against your property."
And that means two things. First, if you don't
repay, you can lose your house to foreclosure. Second, when you
sell the house, you have to repay the loan in full at closing.