Risks of Taking on Too Much Debt
(MONEY Magazine) – Home prices are high and interest rates are low. So why not supersize your mortgage (or tack on a hefty home-equity loan) to get the house of your dreams?
Because, in a word, it's dangerous. Any form of equity borrowing represents a lien--if you default, the bank has the right to take your home. While that outcome is uncommon (most homeowners file for bankruptcy or renegotiate payments before foreclosure), these more likely scenarios have consequences almost as dire:
You could get squeezed by rising interest rates. Americans have been increasingly turning to adjustable-rate loans to get their monthly payments down. Experts warn that once interest rates begin to head up, thousands of homeowners will realize they've stretched themselves too thin. Indeed, mortgage debt as a percentage of personal income has increased from 55% to 73% since 1998, according to Economy.com. Consider this: A $250,000 mortgage at 4.26% interest requires a monthly payment of $1,231; if the rate rises three percentage points (to about the historical average), the payments increase by $417.
You could end up owing more than your house is worth. While U.S. real estate overall has historically appreciated at 6% a year, periods of decline do occur at the local or regional level. If you borrow 100% of the value of your home and the price drops 10%, you'll owe money if you decide to sell.
You could lose your safety net. Many people don't worry about falling home prices because they figure they'll still be able to make their monthly payments and stay in their home. But what if you need to relocate for a job and have to sell your home? Or worse, confront an unexpected medical expense? In situations like that, it's great to have home equity to fall back on. If you've already used it, notes Coral Gables, Fla. financial planner Harold Evensky, "you've eroded your cushion."
You could limit your retirement options. "That money you're paying to the bank is money you aren't saving for retirement," adds Evensky. Once you stop working, you may want to trade down to a smaller home and pocket the cash gains, or get a reverse mortgage. If you've drained your home equity, your comfortable retirement could disappear along with it. --C.W.