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DebtFreeGuru.com's - Tip of the Week - Monday, September 29, 2003

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Home Equity Debt is Secured by Your Home!

How much home equity debt is too much? The answer depends on how much you owe to other creditors, whether your get a home equity loan or a line of credit, what you are using the money for and whether you have self-discipline.

As mortgage rates continue to rise, many homeowners will ask themselves how much they can safely borrow with a second mortgage - either a home equity loan or an equity line of credit.

The lender is first to ensure against taking out a loan for too much. Lenders are not going to take any unnecessary business risks. They make sure that you can afford it otherwise they wouldn't approve it.

A lender determines that you can afford the loan by comparing your debt to income ratio. Most lenders limit borrows to total debt service payments not to exceed 50 percent of before-tax income.

For example, say you earn $950 a week before taxes or about $4,100 a month - roughly the nation's median household income. Your lender doesn't want the monthly minimum payments on all of your debt - mortgage, equity loan, auto loans, credit cards, and student loans - to exceed 50 percent of that pre-tax income. So, when figuring out your maximum loan amount, it would seek to limit your total monthly debt service payments at $2,050.

Another ratio to consider is the size of the second mortgage as compared to the first mortgage. The rule of thumb is the second mortgage shouldn't exceed 30 percent of the first mortgage. So, if your first mortgage is for $100,000, then the home equity loan or line of credit should be around $30,000 or less.

Another consideration is the type of debt you take on. A home equity loan is a lump-sum amount. You start accumulating interest and making payments the moment you sign the loan papers. Your monthly payments repay the loan over a set period of time.

An equity line of credit acts more like a credit card. You don't have to pay interest until you use from the credit line. This means you 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 pay interest only.

These differences mean that a home equity loan is better to use for a one-time expense. A line of credit is better for continuing expenses, such as a lengthy renovation, or college tuition.

Because in many cases interest paid on these loans may be tax deductible and the monthly payments are frequently lower, many lenders promote home equity loans for debt consolidation and equity lines of credit to be used instead of credit cards.

However, when you do this, you are taking "unsecured" debt and securing it with your home as a second or in some cases a third mortgage. If something were to happen to your income and you could not afford to continue the payments on that obligation, the lender would foreclose on your home.

Also, most people have not been taught or have the self-discipline, to not go out and run up the credit cards they just paid off in the consolidation and end up in serious financial trouble.

So when considering a home equity loan or equity line of credit make sure that it is absolutely essential. Look at all other unsecured possibilities first and use your home only as a last resort. Then, if for some reason you are unable to make some or all of your monthly payments, the only result will be a few bad marks on your credit report and a decline in your credit score, which is certainly more desirable than losing your home.

DebtFreeGuru.com - Tip of the Week - Monday, September 29, 2003

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