If you are considering taking on a sizable home equity loan, be sure to know when you're taking on too much debt. Too often people borrow as much as lenders will possibly let them without ever stopping to consider if that amount of debt is actually right for them.

Be sure to stay on balance. Most people will not be able to buy a home without borrowing, so you should borrow but stay at a reasonable level. Try to keep your mortgage payments between 10 and 12 percent of your gross monthly pay. You might not have the biggest and nicest house, but you will have a comfortable mortgage. Also, try to keep your car payments to 3 to 5 percent of my gross pay. You will have a comfortable car with comfortable payments.

Only spend a maximum of 20 percent of your gross pay on large-scale debts related to your home in order to remain well within a common sense financial plan. However, you still need to consider the whole picture because the kinds of expenses each person has varies.

When considering taking on substantial new debt, there are a few different figures that you should review to see if your personal financial profile still falls within your personal comfort zone. These are the same figures that lenders (banks, credit cards, etc.) will consider when they make a lending decision.

Do you earn enough to make the payments? Do you have so much other debt that it would affect your ability to repay the new debt? Lenders often calculate your debt-to-income ratio to guide them here. This is the total amount of your monthly debt payments, including the new expected debt payment, divided by your gross monthly income.

Is the value of your collateral (usually a home or car) enough to ensure that the lender will recoup its losses, should you fail to pay? To help them here, lenders will often use the loan-to-value ratio--the amount borrowed divided by the value of the collateral.

When preparing to take on new debt, you should always review your credit history with the three large credit reporting agencies (TransUnion, Equifax and Experian) and close any old accounts or correct mistakes. If you've had any bankruptcies or foreclosures, this will be a significant strike against you.

How much cash will you have left over after any down payment and/or loan closing costs? Do you have just enough? Or more than enough?

Lenders also look at how you'll use the money. They might consider a loan to buy an apartment building (where you will depend on rents from tenants to be able to make your payments) riskier than a home mortgage loan, for example.

Always balance your financial profile with your personal level of comfort. Strike a good balance between the two and you'll generally choose the smartest path.

Back to Articles