A Home Equity Line of Credit, also known as a HELOC, is a line of credit that is secured against the equity in your home. Much like a credit card, the HELOC is a form of revolving credit, meaning you can borrow a small or large portion up to your HELOC limit, even make interest only payments and once paid down below the limit, borrow against it time and time again. You could use it to renovate your bathroom one year, make payments and buy a car the next. A HELOC offers great flexibility to manage your finances or to pay for large pre-planned purchases or unforeseen emergencies.
On the flip side, unlike a credit card, because the HELOC is secured by your home, chronic mismanagement of it (repeated payment delinquencies for example) could result in the lender calling it to be paid out in full, which could be no easy feat. Like a credit card, if you are undisciplined about paying down your balance you could end up with a much larger and unmanageable debt accruing interest rapidly, making it even harder to get it under control.
There are two main types of HELOCs, one that is combined with a mortgage and one that stands alone.
This is the most common type of HELOC and most Canadian lenders offer it, though sometimes under their own proprietary label. The credit limit on the HELOC portion when combined with a mortgage, cannot exceed 65% of your home’s market value. The mortgage portion, either fixed or variable, can go up to another 15% of your home’s value, so combined the HELOC & mortgage portion cannot exceed 80% of your home’s market value. If the value of your property increases, you can approach your financial institution to increase your HELOC limit back up to 65% of its new value, provided, of course, you qualify for the increase based on debt servicing ratios. However, one thing to keep in mind is that if the value of your home drops for whatever reason, your financial institution, at their own discretion, could decrease your HELOC limit and if maxed out at the time, this could be especially problematic.
With this type of HELOC, you make regular mortgage payments according to a set schedule, paying down the principal and interest on your home as you normally would with the fixed or variable portion of the mortgage. The HELOC portion, however, is not tied to a fixed repayment schedule; rather you are only required to pay interest on the money you use if that’s what you wish.
Purchasing a Home With a HELOC Combined with a Mortgage
It is possible to finance the purchase of a first or second home with a HELOC combined with a fixed or variable term mortgage. The portion you finance with a HELOC can’t be more than 65% of the purchase price or market value, whichever is lower. The remainder would need to be financed by a fixed or variable term mortgage, with the combination of the two not exceeding 80% of the value or purchase price, leaving you to come up with the remaining 20%. For example, if you buy a home worth $1 million, you pay $200,000 in a down payment and the balance owing is $800,000. The maximum you could finance with a HELOC is $650,000 ($1million x 65%), and the remainder, $150,000, would need to be financed with either a fixed or variable term mortgage ($800,000 – $650,000).
The benefits of buying a home using a HELOC are: the flexibility of repayment, the fact that you’d have reusable credit as you pay down your HELOC, and as well, the possibility of tax deductions if you choose to invest the money from the HELOC in non-registered investments such as stocks and bonds. However, while HELOCs generally have lower interest rates, when compared to personal lines of credit, their rate, like personal lines of credit, will also likely fluctuate with any and all changes in the prime rate.
A stand-alone HELOC is not related to your mortgage at all, it is simply a line of credit secured by your home. The maximum credit limit is 65% of your home’s purchase price or market value whichever is lower, and the only way its limit will go up is with an increase in property value. Just remember that your existing lender will require you to qualify for the increased limit.
Substituting a Stand-alone HELOC for a Mortgage
You could use a stand-alone HELOC as a substitute for a mortgage, but you will need to put at least 35% down. The main benefit of this option is its repayment flexibility. You choose how much principal you want to pay down, when you want to do it, and you won’t suffer any repayment penalties or restrictions; normally you can pay down as little or as much as you want so long as you are making the minimum interest only payments. Keep in mind though, while this is normally the case, in an extreme market (falling values) and/or chronic issues with maintaining your HELOC account, your lender may require more than just interest only repayment.
As well as being aware of the basic types of HELOCs, HELOCs of either type can vary in their specific features depending on the lender. Here’s what to look out for:
Maximum and Minimum amounts: The 65% mentioned above is a maximum legal amount that Canadian banking institutions are allowed to lend up to. However, based on your personal financial situation you may qualify for less than 65%.
Revolving Credit/Balance: As mentioned above, a HELOC is like a credit card in that you can use the money, make payments and draw down again without having to enter into a new contract. However, it is possible in the case of a HELOC combined with a mortgage, that your credit limit could increase when the equity in your home increases, provided of course you qualify for the increase.
Sub-divide Lines: It is sometimes possible to divide your HELOC up into smaller portions that are used for different purposes, this allows better tracking of the funds and interest costs.
Option to Convert to Fixed: The interest rates for a HELOC are variable, however you can convert a portion to a fixed or variable rate term based on financial institutions qualification requirements.
Like all loans, you need to apply for a HELOC and prove to the lender that you are low risk. As mentioned above you will need at least 20% equity in your home (this can be a down payment or existing equity) when in tandem with either a fixed or variable mortgage product, or 35% if you are using a stand-alone HELOC as a substitute for a mortgage. In addition, you will need:
Be aware as well that there are fees associated with setting up a HELOC. These are fees such as legal fees, title search fees, application fees, home appraisal fees, taxes and insurance fees just to name a few. The good news however is that provided you’ve got room in your HELOC, these can typically be paid for out of the new HELOC.
Every type of loan comes with advantages and disadvantages. Which loan is right for you depends on your specific situation.
While a HELOC is enticing because of its flexibility, it is not the only type of home equity loan. If a HELOC is not right for you, you might look into:
If you opt for a HELOC it would be good to have a plan in place detailing exactly how you’re going to use it and how you’re going to repay it. Remember that different lenders will offer different HELOC packages, and you could benefit from shopping around.
If you’re unsure whether a HELOC is right for you, give us a call. We can advise you on the best solution for your situation and goals.