Home equity debt can be too much for some

Oakland Tribune, Sep 21, 2003 by Holden Lewis

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 -- either a home equity loan or an equity line of credit.

The lender is your first line of defense against taking out a loan for too much. "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."

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.

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 your 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.

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.

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."

The benchmark 30-year fixed-rate mortgage fell 16 basis points to 6.06 percent, according to the Bankrate.com national survey of large lenders. A basis point is one-hundredth of 1 percentage point. The mortgages in this week's survey had an average total of 0.39 discount and origination points. One year ago, the mortgage index was 6.08 percent.

The 15-year fixed-rate mortgage fell 17 basis points to 5.37 percent. The one-year adjustable-rate mortgage fell 7 basis points to 4.09 percent.

E-mail Holden Lewis at hlewis@bankrate.com .