Loans are an extra hand in paying for larger expenses. For homeowners, a home equity line of credit, or HELOC for short, is a great financing alternative – if used wisely. News have reported that Canadians have over $300 billion in HELOC debt. And as home prices rise in major cities, many have decided to use their equity to good use.
Here we explain the basics of HELOC loans.
A definition of “equity”
Your home equity is your most valuable asset, part of your total net worth, and one of the perks of homeownership.
But what is it?
Home equity is your real property value or the amount of property you actually own. It is the difference between your home’s value and the amount you owe on mortgages (or mortgage balance).
As a homeowner, you technically own the property. However, since you used a loan to pay for it, your property is used as collateral. If you bought a home for $350,000 and made a 20% down payment, your mortgage will be the remaining $280,000. In this scenario, you only own 20% ($70,000) of it since you haven’t paid the loan yet. The remaining money is being used by your lender as collateral. As you make mortgage payments towards the principal, you build equity in your property. The day you make your final mortgage payment is the day you own 100% of your home.
What is a Home Equity Line of Credit?
A home equity line of credit is a financing option for homeowners that have built up enough equity in their property. The loan will be based on your equity and secured against your home. In Canada, lenders can offer you up to 65% of your home’s market value.
This type of loan is flexible and convenient. It can be used for different purposes such as renovations, starting a business, tuition or paying other high-level debts. Unlike other loans, the total funds are not available at once. Instead, a HELOC loan works as a credit line with pre-approved funds. As long you have a mortgage, you can withdraw money whenever the funds are needed. You’ll be able to access your loan through your credit card, online banking or checks.
However, there are some disadvantages. Because your home is used collateral on a second mortgage, the lender might take your home, and you’ll face foreclosure if you fail to pay your mortgage on time. Borrowing against your greatest asset doesn’t come without risk. And at the same time, you are reducing your home equity. Once you sell your home, the profit could be less than what you expected.
Types of HELOC loans
In Canada, there are two types of home equity lines of credit.
1. HELOC combined with a mortgage or readvanceable mortgage
A HELOC loan tied to your fixed term mortgage and amortization period. There will be a repayment period where the mortgage principal and interest payments will be required on a regular basis. Once you start paying back your mortgage, your home equity line of credit will go up as well.
For this type of loan, you’ll need at least 20% of home equity or down payment.
2. Stand-alone product:
This HELOC loan is not combined with a mortgage. It acts as a revolving credit product secured against your home. As you pay the mortgage principal, your credit won’t increase. It will remain the same.
For this type of loan, you’ll need at least 35% of home equity or down payment.
Interest rates for HELOC loans
HELOC loans usually have very competitive rates since it is secured against your home’s value. It might even be lower than those for first mortgages. And since you only withdraw money whenever you need it, interest rates won’t start incurring immediately. You will not be paying interest in money you haven’t used.
Rates are generally variable at first, meaning that they will depend on the lender institution’s prime rate or the Bank of Canada’s benchmark rate. After some years, you can talk to your lender about obtaining a fixed rate.
When negotiating your interest rate, you need to consider the consequences of each type of rate. With a variable rate, you are subject to changes on the benchmark. If the rates hike, your payment will increase as well. This is where a flexible and sizeable monthly budget comes in handy. On the other hand, at a fixed rate, you’ll save on the short term but it might be possible that you’ll pay more interest in the long run.
How to apply
Banks and private lenders are your venues to apply for for HELOC. If you already applied for a mortgage, the application process will be familiar. You’ll be required to bring income and tax statements and current mortgage details, and your lender will proceed to check your credit score, assess your home’s value through a home appraisal and perform the mortgage stress test to decide how much you can borrow.
If you’re not a fan of the stress test, you can skip it. Only federally regulated lenders are required to use the stress test. Instead, you can choose to go for a credit union or other lenders.
And here is something to remember: a HELOC loan isn’t free. There will be application fees to pay such as lender fees, home appraisals and real estate lawyer fees.
A word of caution
A home equity line of credit is only for those with financial discipline. Before applying for the loan, there are a couple of things to consider.
The first is that home equity line of credit is not a bank account that you can withdraw from whenever you please. Eventually, every cent has to be paid back – and with interest. The money available is not for trivial expenses. This means no vacations or fancy purchases should be funded through HELOC. The loan is intended to improve your financial situation or add value to your home.
A HELOC loan should be never be taken twice. These loans shrink your equity every time. If the market value of your home decreases, you’ll end up owning more of a house that is worth nothing. And if you are unable to pay back, your home will be on the line.
Consider your future financial plans before getting another loan. Your savings should be enough to cover emergency funds, retirement plans, and other bills. Financial stability should always be your number one priority.
- Don’t borrow more than what you need.
- Always see if your savings are enough before taking out another loan.
- Make regular monthly payments.
- Pay off your HELOC first before your first mortgage.
- Remember your accumulated debt before making any long-term financial plans.
- Use the loan to add value to your home.
- Talk to different lenders and mortgage professionals to get the best rate.