While there are many joys to owning a home – including having a potential life-long dwelling – a big benefit is being able to build large amounts of equity over time. That equity can come in handy to secure funds with low cost rates, either as a HELOC or as a one off loan.
There are plenty of options out there for long-term borrowing, including taking out a second mortgage to free equity on a home. However, Canadians are increasingly turning to HELOCs as a mean to borrow against their home.
Indeed, HELOCs have become the most popular form of home equity borrowing. According to the Bank of Canada, in 2017 more than 2 million households took out a HELOC, compared to 380,000 who took second mortgage equity on their home.
So, why has the HELOC become such an important borrowing tool to homeowners in Canada? In the following page we will delve into the HELOC and explain every aspect, while also highlighting whether this type of debt is a good decision.
What is a HELOC?
HELOC stands for home equity line of credit. It leverages the equity in your home as collateral for a revolving line of credit.
Home equity is the difference between what your home is worth and the remainder owed. It can be thought of as the percentage of your home which is yours.
For example, imagine your home mortgage is $600,000. If you have a $200,000 balance remaining, you have $400,000 in home equity.
HELOCs are a good option for borrowing because the credit is secured against the equity in your home, which means you can borrow large sums at competitive interest rates. While those rates will not be as eye-catching as your first mortgage, you will be paying less interest than unsecured borrowing methods like credit cards or personal loans.
How does a HELOC work?
A HELOC is a revolving line of credit secured by your home. Draw from your line of credit as needed. You only pay back the amount that you actually choose to spend (with interest), not the total amount you are approved for.
Unlike a second mortgage where you get the money upfront, a HELOC provides a line of credit that you can dip into as you need. While it represents an intriguing borrowing opportunity, like any financial decision there are risks attached. Most notably, the HELOC lender gets a lien on your home. In extreme cases, if you miss payments you risk losing your home.
Remember, when you take out a HELOC, you are borrowing against the equity on your home. This means a lien on your home, so discipline is necessary.
HELOC Pros and Cons
No financial decision is a guarantee of success. If they were, things would be much easier. When considering any borrowing or investment, you need to weigh the advantages and disadvantages before making a decision. HELOCs are no different, and before you take on this major financial commitment, you should consider the following pros and cons:
- You do not pay closing costs: With a good credit score, you may not owe closing fees when setting up a HELOC.
- No fees to withdraw cash: You can tap into your credit at any time without paying a fee. Alternatives like credit cards and chequing accounts do carry withdrawal fees.
- Low-interest rates: HELOCs have some of the best low interest rates of any borrowing method. Not quite as good as your first mortgage, but much lower than unsecured debt.
- Converting to a fixed-rate product: Most HELOC lenders allow customers to lock into a fixed-rate from a variable-rate mortgage.
- Flexible payoff: You can pay off a HELOC when you want, but check the small print of your loan agreement to ensure there are no fees for closing the debt early.
- Flexible spending: One of the best aspects of a HELOC is it provides a line of credit you can access when you want. You do not need to justify how you will spend the loan and can spend as you wish.
- Easy to be tempted by low payments: Having a minimum monthly payment that is just the interest rate is an attractive perk of HELOCs. However, it can be tempting to only pay off the minimum and the credit payments never go away.
- Interest rates may rise: While lenders allow customers to switch to fixed rates, HELOCs start as variable-rate loans. This means interest rates could rise in the future and you end up paying more.
- Using your home as a piggy bank: That dream vacation to Paris may seem tempting, and a HELOC is a good way to pay for it. However, there are inherent risks in securing a major loan against your home.
- Hidden fees: Lenders give you a credit to make money. Yes, the interest rate is the primary way of making money off of customers, but annual and other fees can also be attached to HELOCs.
- Losing home value: If your home value decreases over time, the remaining equity will erode, making it harder to sell the property or refinance it in the future.
How do I get a HELOC?
Millions of Canadians have taken out a HELOC, and the qualification conditions tend to be generous. Customers can take a HELOC as either a stand-alone credit or as an addition to their existing mortgage. How much equity is available on your home is the most important qualification for a HELOC.
Other criteria include your debt-to-income ratio, which shows the lender how capable you are of repaying your credit. A good credit score is also important to get a HELOC loan. Proof of income is also a vital component of being accepted by a lender.
Criteria for qualifying for a HELOC:
- Amount of home paid-off
- Debt-to-income ratio
- Credit score
- Proof of income
If you meet all the qualifications, the easiest way to get a HELOC in Canada is to compare rates online. Use our tool to get your best HELOC rates from top lenders.
How large a HELOC can I get?
Suppose your home is worth $600,000. You may qualify for a HELOC of up to $390,000. That represents 65% of the value of the home.
Beyond that, if anything is still owed on the mortgage that needs to be subtracted and would affect your maximum. Here is the formula:
HELOC maximum = home value x 80% – remaining balance
Let us assume that a $200,000 balance still remains on that $600,000 mortgage.
$600,000 mortgage x 80% = $480,000
We subtract the remaining balance to get $280,000, your maximum HELOC. Since $280,000 is less that 65% of the value of the mortgage, it should qualify.
There are restrictions on how much you can borrow on a HELOC in Canada. Specifically, the line of equity must be a maximum of 65% of the appraised value on your home when your mortgage is with a federally-regulated lender. If the lender bundles the HELOC with the remaining balance on your first mortgage, you can potentially borrow up to 80% of your property’s value.
What is a good HELOC rate?
A great HELOC rate is the prime rate +0.5% to 1%. In Canada’s current low-interest climate that means that well-qualified borrows could potentially get a rate as low as 2.95% to 3.45%.
HELOCs have more competitive interest rates than types of unsecured debt, but not quite as good as your first mortgage. HELOC remain one of the cheapest ways to access credit. For example, with a credit card, you could be facing interest rates of 20%.
Want to see what HELOC rate you could qualify for? Get a quote in seconds.
How do you calculate a HELOC payment?
A minimum HELOC payment is interest only. It is calculated using the following formula:
Payments = HELOC balance x [interest rate/12 month]
Imagine that you have drawn $50,000 on your HELOC. Your annual interest rate is 4%. You would owe $2,000 per year interest or $166.67 per month.
Keep in mind that you need to make larger payments than this if you want to pay down the $50,000 borrowed.
What can a HELOC be used for?
Borrowing using a HELOC is one of the most flexible ways to unlock large or smaller sums of money and use the funds as you wish. There are endless ways you can use your HELOC credit, including the following popular uses:
- Home improvements
- Debt consolidation
- Pay higher education fees
- Down payment on a property
- Medical expensive
- Pay off student loans
- Start a new business
HELOC vs refinancing
It is important to not get a HELOC confused with refinancing your mortgage. A HELOC frees up equity as credit, providing you with extra spending money. On the other hand, refinancing is renegotiating and changing the terms of your existing mortgage. When you refinance a mortgage, you essentially end your current mortgage contract and take on another.
This means you can get a more favourable interest rate and borrowing conditions. However, a refinance will not give you access to ready cash to spend on what you like. A HELOC provides a stream of credit whenever you want it.
You can find out more about refinancing your existing mortgage on our mortgage refinance page.
HELOC vs home equity loans
HELOCs, home equity loans and second mortgages are easy terms to mix up. All provide credit in exchange for a lien on your home. Fundamentally the difference is that a HELOC is a line of credit, the terms second mortgage and home equity loan both refer to a lump-sum loan secured against your home.
Why pick a HELOC
- You want financial flexibility
- You may only spend some of what you can borrow
- Only pay back what you use
- Borrow up to 65% of home’s market value
Why pick a second mortgage
- You want a lump-sum payment
- You know how much you want to borrow
- You are comfortable with long-term monthly payments
- Borrow up to 80% of the home’s value (minus balance of first mortgage)
A second mortgage is worth considering versus a HELOC as a borrowing method to tap into your home equity. Pay a visit to our second mortgage guide to find out more about this financial solution.
HELOC vs reverse mortgage
In some ways, a reverse mortgage allows you to take more control of your financial borrowing. In fact, it is you who becomes the lender as you sell your property to the lender. If you are the title owner of a home, you can sell it to a lender who will make regular payments to you while you continue to live there!
However, your equity in the home decreases over time as the lender buys more of it. Importantly, you continue to be the titleholder. When the reverse mortgage matures, you can sell your home to pay it off, or the lender will own the property and sell it if you pass away or default. You do not pay back the loan until you sell or die.
If you do pass away, the lender will sell your property and pay out any additional equity beyond the appraised value to your estate. While a reverse mortgage gives you a stream of funds like a HELOC, the structure is drastically different. Moreover, reverse mortgages are only available to homeowners who are 55 or older.