Guide on Home Equity Line of Credit (HELOC) | Fivewalls

Guide on Home Equity Line of Credit (HELOC) | Fivewalls

Sellers, Buyers
Last Updated: Jan 26, 2021

When you own your home, you may be able to access a home equity line of credit. This guide will help you understand what a HELOC is, the pros and cons of a home equity loan, and the various things you can use the funds for. 

What is a Home Equity Line of Credit (HELOC)?

A home equity line of credit, often shortened to HELOC, is a revolving credit line that uses your home as collateral. Generally, HELOC rates in Canada are much lower than what you would find on traditional lines of credit, but the total value of a loan cannot exceed 65% of the value of your property. 

Understanding Home Equity 

Before we dig into home equity lines of credit and HELOC rates in Canada, we must first answer the following question: What is home equity? 

Home equity refers to the amount of your home that you have already paid off. In other words, it is the difference between the value of your property and how much you still owe on the mortgage. 

Home equity is a great way to build wealth since the amount you have will increase over the long run. The more you pay down on the principal part of your mortgage, the faster your equity will grow. Using this equity is a great way to borrow large sums at a reasonable interest rate - and you do not have to sell your home!

Basics of a HELOC

A home equity line of credit gives you access to up to 65% of the value of your home. It is important to note, though, that your total outstanding mortgage plus the HELOC cannot exceed 80% of the property value. 

How Much You Can Borrow

Determine the fair market value of your home, then subtract the balance of your mortgage. This value is how much equity you have available. 

Next, multiply the fair market value by 80% to determine the total outstanding debt you can have. Subtract the remaining mortgage amount from this value to determine the amount of equity you can access through a home equity line of credit. Note that the HELOC cannot exceed 65% of the total fair market value.

For example, let’s assume that your home is worth $650,000 and you owe $300,000 on the mortgage:

    $650,000 - $300,000    = $350,000 Home Equity

    $650,000 x 80%    = $520,000 Maximum Debt Allowed

    $650,000 x 65%    = $422,500 Maximum HELOC Allowed

    $520,000 - $300,000     = $220,000 HELOC Accessible Funds

In this scenario, the maximum total loan amount is $520,000, but since you still owe $300,000 on the mortgage, you can only borrow $220,000 with a HELOC.     

Consider using a HELOC calculator to determine how much of the equity in your home you can access. 

Accessing Your Funds

The home equity line of credit gives you access to the funds as a revolving line of credit. You do not receive the entire amount as a lump sum, but rather, you can borrow as much as you choose for the duration of the draw period. 

On average, the draw period will last 10 years, and during this time, you will only pay interest on the amount withdrawn. The interest rate is calculated daily using a variable rate that is linked to the Prime rate. You may have the option to pay extra towards principal during this draw period, but the specifics will depend on your loan contract. 

Paying Off Your HELOC

After the draw period has ended, you can either ask for an extension or enter the repayment phase. Once you enter the repayment phase, you may no longer access additional funds, and you are required to make payments that consist of interest and principal until the balance is paid off. 

Most lenders allow you to repay this balance over 20 years, And the repayment options may vary depending on your contract. Remember that the monthly payments will increase significantly at this time since you are now responsible for both the interest and principal. 

A home equity line of credit uses your property as collateral, so if you allow this loan to default you risk losing your home. 

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How to Qualify for a HELOC

Qualifying for a home equity line of credit is very similar to applying for a mortgage. This is essentially a second mortgage on your home, and banks will underwrite them based on your creditworthiness, the value of your home, and your debt-to-income ratio.

The lender will request proof of ownership, the details of your existing mortgage, and a property appraisal. You will also need a lawyer or a title company to register the property as collateral for the new loan. The lender will calculate what is called a combined loan-to-value ratio, or CLTV. This metric shows how much of your home's equity you can access.  

Once you are qualified for the home equity line of credit, you will need to pass a stress test and provide a minimum down payment or equity of 20%. This will show that you can afford the payments even if interest rates increase above your current contract rate. If you work with a credit union or other lender that is not federally regulated, you may be able to forego the stress test. 

Pros and Cons of HELOCs

Like with any loan vehicle, home equity lines of credit have advantages and disadvantages. Let's review the pros and cons associated with this type of borrowing:

Pros of HELOC:

An advantage of a home equity line of credit is that it allows you to access a lot of money. The interest rate on HELOCs in Canada are much lower than rates on unsecured loans and credit cards, and you only have to pay back interest on the amount you borrow for the first 10 years. 

Since this is a revolving line of credit, you can borrow as little or as much as you want up to the available credit limit that was offered. This flexibility is very convenient and can help you meet your borrowing needs without reapplying for other loans down the road. 

Most HELOCs allow you to pay them off early without any penalty. That means you do not have to carry the entire debt for the duration of the loan term. 

Cons on HELOC:

One of the major drawbacks of a HELOC is that having access to large amounts of credit makes it easier to spend money faster. If you are not careful, this can leave you with a significant debt that you will have to carry for a long time.  

During the draw phase of the HELOC, you only need to make interest payments. The amount you owe each month can almost double, though, when you enter the repayment period. This type of borrowing requires discipline because you need to make sure that you are financially ready to handle those increases. 

A home equity line of credit can also make it difficult to change your mortgage since another lender may require you to pay it off in full before you can move forward. 

Similarly, anytime you miss payments on this loan you face the risk that the lender will take possession of your home. 

What are HELOCs Used For?

Home equity lines of credit can be used for a wide variety of things, but the most popular uses are home improvements, debt consolidation, and paying for education. 

Home Improvements

If your home needs major renovations, like a new kitchen, roof, or bathroom, a home equity line of credit is a great source of funds. Home improvement is one of the most common reasons to take out a HELOC, especially since the idea is to complete renovations that will ultimately increase the value of your home. 

Although you have to repay the HELOC, the renovations could theoretically pay for themselves as long as the home's value continues to increase as a result. 

Another benefit to using a home equity line of credit for home improvements is that you can deduct the interest that you pay on this loan up to $750,000, so long as the funds are used to improve the home that is securing the loan. 

Before you move forward with renovations, make sure that you do your research and confirm that the return on investment is worth it. 

Debt Consolidation

Accessing the equity in your home through a HELOC is a great way to consolidate debt that carries higher interest rates at a much lower rate. Many homeowners will use these funds to pay off credit cards, personal debts, and auto loans. 

The only downside is that you're converting an unsecured debt - meaning loans that do not have any collateral - to a debt that is now secured by your home. However, if you are struggling to make the minimum payments on your credit cards and your balance is continued to rise because of the high interest rates, a home equity loan may help you pay these down faster. 

If you do use a HELOC to consolidate your debt, be sure that you do not run up your credit cards again after you have paid them off - remember that you still have to pay off your home equity line of credit! 

Paying for Education

A HELOC can also be used to fund a college education. If your lender allows this option, you may be able to avoid student loans and borrow funds at a much lower interest rate. In addition, repayment terms on a home equity line of credit are much longer, so you can reduce the monthly payment requirements. 

Although this can often be a promising alternative, make sure to confirm that the calculation support using your home equity to pay for college. When you default on a student loan it will hurt your credit, but if you fail to make payments on the HELOC you could potentially lose your home. 

Research all of your options first, and make sure that this is the right financial decision before you move forward!

HELOCs v.s. Home Equity Loans

You may be wondering, what is the difference between a HELOC and a home equity loan? Although both types of vehicles allow you to access the equity in your home, they function very differently, and you should not use them as interchangeable terms. 

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How You Access Your Funds

A HELOC is a revolving source of credit that is very similar to a credit card, so you can access the funds whenever you choose. A home equity loan, on the other hand, will provide you with a lump sum of cash in a one-time disbursement. 

In other words, a home equity line of credit provides much more flexibility and gives the option of obtaining funds only as they are needed. 

Applicable Fees

While a HELOC does not have any closing costs associated with it, a home equity loan is just as involved as your original mortgage. You will have to pay closing costs like origination fees, appraisal fees, recording fees, and loan processing fees, so the cost of obtaining these funds can be much higher. 

There are some fees involved with a HELOC, but they are usually much more affordable. 

Interest Rates

A home equity line of credit uses a variable interest rate. The interest rate on the funds you borrow will change based on the prime rate, so there is the risk that your payment requirements will increase. Since a home equity loan involves a one-time payment, most lenders will offer a fixed interest rate. As a result, your repayment schedule will generally be fixed. 

Questions to Ask Your Lender When Considering A HELOC

When you start considering a home equity line of credit, work with your lender to ask questions about how the process works and how it will affect your financial situation. 

Ask them what their qualification requirements are so that you can prepare the necessary documents and determine whether you will meet the criteria for obtaining the HELOC.

You should also ask them what current interest rates are and what the lowest rate they can offer you is. Remember that one of the main benefits of a HELOC is lower interest rates, so make sure that you do not end up with a loan that has a higher interest rate than other forms of credit! 

Another question you should ask them regarding interest rates is how much notice they will give you before a rate increase. Variable interest rates will change from time to time, and you should know how much notice will be given before your monthly payment will be adjusted. 

Similarly, verify what fees will apply and whether or not there is a prepayment penalty. This can help you avoid paying any unnecessary fees in the long run. 

Understanding Your HELOC Contract

When you decide to obtain a home equity line of credit, you must understand all of the terms written in the contract. 

The interest rate provided can vary depending on how your loan is set up. Most HELOCs use variable interest rates that are based on the prime interest rate. For instance, your home equity line of credit can have a rate of prime plus 1%. 

If the lender's prime rate is 2.50%, then the interest rate on your loan will be 3.50%. You may be able to negotiate the rate that the lender is offering, but they will consider things like your income, credit score, and the value of your home before doing so. 

The lender may also have the option to change the rate at any time, and this will affect the amount you have to pay each month. Read your contract thoroughly to determine how much notice they must provide before adjusting interest rates. 

Understanding the fees associated with your HELOC is also important. Most lenders will require a home appraisal, and you will be responsible for the fee needed to send somebody to assess the value of your home. 

There is usually a fee for registering the collateral on your home, as well as a title search to ensure that there are no additional liens on the property. You may also see discharge cancellation fees that will remove the HELOC from the title of your home once you pay it off. 

Make sure that you understand the total cost of obtaining a home equity line of credit before you sign the contract. 

Key Takeaways

A home equity line of credit allows you to access the equity you have built for anything from home renovations, debt consolidations, paying for college, and more. The loan is secured against your home, and because the property is your collateral you will likely be able to obtain a lower interest rate than traditional borrowing options.  

You can access your home equity like a credit card, meaning it is a revolving source of funds. Consider everything from the fees, flexibility, and interest rates before you move forward and clearly defined how you plan to use the money you borrow so that you don't end up taking too much! 

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