A home equity line of credit, or HELOC, is a secured, revolving form of credit that uses your home as collateral. Like other lines of credit, a HELOC can help you make major purchases or consolidate debt at a lower interest rate than you’d pay using certain credit cards or personal loans.
HELOCs can be a convenient way to access cash, but you should understand how they work and how much they might cost you before tapping into your home equity.
HELOCs vs. home equity loans vs. mortgages
HELOCs are just one type of credit product associated with home equity. It’s not unusual for people to confuse them with home equity loans and mortgages.
A HELOC and a home equity loan differ in a few key ways. First, HELOCs are a revolving credit product, which means you can access funds as you need them. A home equity loan, also known as a second mortgage, is doled out in a single lump sum. Second, HELOCs charge variable interest rates, while home equity loans can be either variable- or fixed-rate.
HELOCs and mortgages aren’t quite as similar. A HELOC is a loan that provides cash to homeowners. A mortgage is the loan used to purchase a home.
How a HELOC works
Types of HELOCs in Canada
There are two basic kinds of HELOCs for Canadian homeowners to choose from: those that are combined with a mortgage and those that are not.
Home equity line of credit combined with a mortgage
A home equity line of credit combined with a mortgage is the most common type of HELOC. Most financial institutions offer this type of HELOC, but sometimes brand them using different names, such as a Homeline Plan.
The mortgage portion of this HELOC is a standard home loan with a term and amortization period where you make regular payments that go toward both the principal and interest. As you pay off your mortgage and your equity increases, the amount you can borrow with your HELOC also rises. The HELOC portion is a revolving line of credit. As long as you own your home, you’re only required to pay interest on the amounts you withdraw.
Stand-alone home equity line of credit
As the name implies, a stand-alone home equity line of credit doesn’t involve your mortgage. It’s still a revolving line of credit that’s guaranteed by your home, and the maximum you can borrow remains 65% of your home’s market value.
Since this HELOC is not tied to your mortgage, you won’t be able to borrow more as you pay down your principal. You’ll only have access to the amount you’re initially approved for, based on the amount of home equity you have at that time.
Qualifying for a HELOC
Like most credit products, you’ll have to apply and be approved for a home equity line of credit.
The first thing you’ll need is some equity. A minimum of 20% equity is required for most HELOCs. If your equity is sufficient, you’ll need to provide the following:
- Proof of homeownership and mortgage details.
- Evidence of stable employment and a consistent income.
- An appraisal of your home’s current value.
- An adequate credit score.
- Manageable debt levels.
You’ll also be required to pass the same stress test you’d be subjected to when applying for a mortgage.
HELOC interest rates
HELOCs interest rates are based on a lender’s prime rate. For example, if your HELOC interest rate is prime + 2%, and your lender’s prime rate is 6%, the rate on your HELOC would be 8%. That’s not bad considering most credit cards charge 19.99% or more.
HELOCs are variable-rate loans, which means the rate you’ll pay fluctuates based on the Bank of Canada’s overnight rate. Whenever the overnight rate increases or decreases, lenders’ prime rates move the same amount in the same direction.
How much HELOC cash can you get?
If you’re getting a mortgage combined with a home equity line of credit, you can access a maximum of 65% of the property’s market value. But your outstanding mortgage balance combined with your HELOC can’t exceed 80% of the value of your home.
These limits might sound complicated, but it’s actually easy to figure out how much money you can get from a HELOC:
- Take your home’s market value and multiply it by 0.80 (80%).
- Subtract the outstanding balance on your mortgage.
- The remaining amount is how much you can access through a HELOC. As long as that amount doesn’t exceed 65% of the value of your home, you’re good.
For example, let’s say your home is worth $500,000 and you still have $200,000 to pay off. Your formula would be as follows:
- $500,000 X 0.80 = $400,000
- $400,000 – $200,000 = $200,000
- $200,000 / $500,000 = 40%
Accessing and paying off a HELOC
With HELOCs, you’re not borrowing a lump sum upfront. Instead, you’re opening a revolving line of credit. When you decide to access it and how much you use is up to you.
To pay back your HELOC funds, you’ll be required to make minimum monthly payments, which are interest-only. (Interest on a HELOC is calculated daily at a variable rate.) That means no matter how high your monthly HELOC payment might be — and they can be quite high depending on how much you borrow and where interest rates are sitting — you’ll still only be covering the interest on your loan.
Paying off the original loan amount is entirely your responsibility. You can pay it off in a single lump-sum or work away at it month-by-month like you do with your mortgage. To reign in the interest charges and prevent you from having a large debt hanging over your finances indefinitely, it’s best to have a feasible repayment plan in place before getting a HELOC.
Arranging a HELOC is a more complicated and expensive process than setting up a typical line of credit. When getting a HELOC, you can expect to pay the following:
- Legal fees that cover the cost of registering the collateral charge on your home. You might also have to pay a discharge fee if your HELOC is cancelled and the collateral charge needs to be removed.
- Title search fees.
- Administration fees.
- Home appraisal fees.
Is getting a HELOC a good idea?
A home equity line of credit can be a way to access a relatively large amount of cash at a competitive interest rate. The fact that HELOCs are interest-only loans can help lighten the burden of paying them back, too.
There are several scenarios where taking out a HELOC can be advantageous:
- If you’re renovating or updating your home. Because renos will add to the value of your home, using HELOC funds this way can provide a solid return on investment.
- If you’re consolidating debt. Using a HELOC can be an effective debt payment strategy if the interest rate is significantly lower than what you’d pay on another form of credit.
- If you’re paying for education. Using a HELOC to pay for college, university or other professional training can also be considered an investment, one that contributes to you earning more income.
HELOCs aren’t always the best idea, though. Using them to pay for expensive consumer goods means paying more overall due to the interest costs. Using HELOCs to pay for investments can also be risky. If interest rates spike and your HELOC-funded investments fail to pay off, you’ll be losing twice.
Because HELOCs use your home as collateral, irresponsible use and a failure to pay back your debt could result in the loss of your house. You’ll want to expose yourself to the least amount of financial risk possible when spending your HELOC funds.
Pros and cons of a home equity line of credit
- Easy access to credit. Use the funds for anything you want such as buying a rental property, consolidating debt or retirement savings.
- Lower interest rate. HELOC interest rates are typically low, especially compared to credit cards.
- Interest-only payments. Since you need to pay back interest only, you can better manage your cash flow.
- Easy additional payments. There are no penalties when making prepayments.
- Borrow as needed. This is not a lump-sum loan. You can borrow whenever you need the funds.
- Requires discipline to repay. Interest-only minimum payments mean you need to purposefully make additional payments to pay off the loan.
- Risk of overspending. The amount you are approved for can be huge, which may encourage you to spend more.
- Switching lenders can be difficult. If you have a HELOC, you may need to pay it off in full before switching to a different lender.
- You could lose your home. Missing payments could result in your lender taking possession of your home.
A HELOC can provide access to much-needed funds, but you need to have a plan before applying for one. Only borrow what you need to, and try to repay more than the minimum interest payments.
Alternatively, you could ask for a lower limit when applying, so you’re not tempted to spend more than you should. Regardless of how you approach a HELOC, ensure that you understand the terms and conditions and are confident you can pay back your loan.
Frequently asked questions about home equity lines of credit
You absolutely have to pay back a home equity line of credit. HELOCs involve interest-only payments, but you are still required to pay back the original amount you borrowed.
Lenders have different standards, but a credit score of 620 should be enough to get you approved for a HELOC. You will need to pass a stress test and have your overall debt situation evaluated before a lender determines how large a HELOC to provide you.
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