By: Ian Mucignat, CFA
What happens to someone that desperately needs money and tries to borrow it? Either they can’t get it because their application / credit is lacking or they will be forced to pay more for it. For example, take someone who has lost their job temporarily and has fell behind on important bill payments, such as the mortgage. Even though this person may have a great deal of equity in their home, they will have a great deal of trouble trying to access it if they aren’t able to provide “confirmable income”.
On the other side, does it make sense to borrow when money when you don’t need it? Not really. Why would someone pay interest on a loan that you don’t need? Enter the Home Equity Line of Credit (HELOC) as a solution.
A HELOC is a revolving loan that is secured by the value of the property. The revolving part means the borrowed amount can go up or down to a specific limit. Kind of like a credit card. The fact that it’s secured by a property (the home) means there is something behind it to give the lender/bank additional safety. This, in turn, provides the lowest rates possible. A real piece of property is the best collateral available.
How HELOC’s work
At the time of underwriting, a credit limit is established up to 65% of the value of the home. Usually an appraisal is completed to verify the home value too. In some cases, there are combined mortgage products that allow a HELOC and a traditional amortizing component that can bring up the borrowing to 80% of the value of the home.
In the majority of cases, HELOCs are done as refinances at renewal time. As the homeowner pays down the mortgage on their property and/or the value of the home increases then equity is created. This is typically when the equity is accessed because it now exists. First time buyers especially will usually put only 5-20% down payment on their purchase and so it takes time to build equity.
The interest rate is based on the financial institution’s prime rate and will fluctuate as the prime rate goes up or down. Currently at the time of writing, the prevailing HELOC rate is Prime + 0.50% at most financial institutions. Prime is 3.20% so the resulting rate is 3.70%. The interest is compounded monthly instead of semi-annually as most mortgage payments are calculated.
The payments are usually monthly and are Interest Only. This can be trap for some people, much like some people only pay the minimum payment on a credit card.
We already touched on one key benefit in the introduction. A HELOC provides access to money at times where you don’t have to qualify for it. A great example is a job loss or transition in employment. The qualifications for a mortgage require the confirmation of income. Somebody that is transitioning to a self-employed career has to show two years of income tax returns. Banks will consider someone who is on an employment contract to be self-employed, even though they may be deducted at source for taxes.
Another benefit, is they are re-drawable. This means that as you borrower and repay, you can re-borrow it again, similar to a credit card. You can borrow for whatever reason, pay it down, then do it again. It unlocks the equity in your home to do things such as renovate or make large purchases.
HELOCs are fully open too, which means you can pre-pay it at any time without incurring a prepayment penalty. Furthermore, while the equity is on standby, there is no cost. For example, an individual that has a zero balance and a $900,000 line of credit will pay $0 in costs for not utilizing the line of credit. If they borrow $200 from it then they start accruing and paying monthly interest on the balance borrowed. The fact that they have $899,800 in available line of credit does not add to the cost of about 62 cents per month.
HELOC’s can provide leverage (when done safely) for the right investment opportunity(s). The interest paid is tax-deductible too when the investment asset is expected to earn income. The purpose for borrowing to invest could be in the stock market, a business idea, rental property, etc. Furthermore, you can even use the line of credit to borrow a down payment on a second property, such as a vacation property.
As mentioned earlier, HELOCs are similar to credit cards and there can be a temptation for some people to use the available credit like ATM machine. People that “budget challenged” and prone to spend should not apply for HELOCS.
Perhaps for these people that may run amuck, they can set up some mitigation strategies. For example, they can institute some “ground rules” such as only borrowing on under certain conditions such a job loss. Or, they can work with another trusted person to help control the accessibility of the funds.
HELOC’s also have a higher cost of borrowing than a closed mortgage because they are fully open and they are compounded monthly. This can be mitigated through a combined product that allows for a Line of Credit and an amortizing portion. When a loan is expected to be paid down slowly over time it can be locked into a term at a better interest rate.
You might want to apply soon. It is my opinion that our policy makers will start to dislike HELOCs in the time to come. There is legitimate concern that Canadians like debt too much and the government will reign it in (see chart).
In addition to the possibility that HELOC’s will become harder to obtain, the mortgage rules are changing in January 2018 to introduce the new stress test. This will make it more difficult to apply for a HELOC too. Depending on the details of your existing mortgage, why not secure this now while you can?
About the Author:
Ian Mucignat, CFA, is an independent mortgage agent at TMG The Mortgage Group. He graduated from Wilfrid Laurier University with a Bachelor of Business Administration, minoring in Economics and is a CFA Charterholder. Ian has worked in the mortgage industry since 2000 at lenders, banks, and brokerages. If you are purchasing, renewing, or refinancing your mortgage don’t hesitate to contact Ian directly for a free consultation.