The terms Home Equity Line of Credit (HELOC) and Home Equity Loan may appear similar to someone who is new to Canadian real estate terminologies. They mean different things and I will attempt to clarify that in this article. For more on mortgage/ real estate terms and definitions, check out this article.
What Is A HELOC?
A home equity line of credit is a revolving line of credit that is secured against your property or home. Like any other credit (example, credit cards), you are loaned money at a certain interest rate and required to make minimum monthly payments on the amount of money you borrow. Interest rates on a HELOC are usually tied (indexed) to the prime rate and will fluctuate over time i.e. variable interest rate.
You can borrow up to 65% of the value of your home through a HELOC. When combined with your amortizing mortgage, you can borrow no more than 80% of the value of your home. Essentially, since your total loan-to-value ratio cannot exceed 80%, to access a HELOC, you should have accumulated at least 20% equity in your home.
Example: Assume your house is valued at $450,000. Applying a maximum loan-to-value of 80% amounts to a total of $360,000. If you still owe $300,000 on your mortgage, then the maximum HELOC you can borrow against your home is $60,000 (i.e. $360,000 – $300,000).
HELOC vs. Home Equity Loan
Unlike a HELOC, a Home Equity Loan is different in that funds are made available to the homeowner on a one-off, lump-sum basis. Interest rate on the loan is usually fixed and higher than for a HELOC. Similar to a conventional term mortgage with fixed interest, fixed monthly payments that include both principal and interest are required when you take out an home equity loan. An home equity loan is also referred to as a “second mortgage”.
Advantages of a HELOC
- Ongoing access to funds when you need it: A HELOC provides access to funds that can be used for major projects such as home renovations, investing, down payment for a second property, kids college tuition, and debt consolidation.
- Pay interest only on amounts withdrawn: You only pay interest on the amount withdrawn and don’t have to pay interest if no debts are outstanding.
- Open: Funds can be used for whatever you want and whenever. You can borrow, pay back, and re-borrow. You can also pay back the entire principal loan at anytime without incurring penalties.
- Secured loan = lower interest: Interest rates offered for HELOCs are usually lower than available through other lines of credit. This is because with your home is being used as a collateral, the loan qualifies as low-interest debt.
- Interest may be tax-deductible: If you use funds from your HELOC to invest in the financial markets, the interest paid on that portion of the loan may be tax-deductible. There is a also a strategy developed by Fraser Smith and know as the “Smith Manoeuvre” that can make your mortgage become tax deductible. See his book on the strategy here.
- Interest-only payment: HELOC’s give you the option to only pay interest for a period of time (draw period).
Disadvantages of a HELOC
- A debt is a DEBT: Debt can sometimes be a good thing (like if you are putting borrowed funds towards a worthwhile business venture or investment, and such). However, if you’re just piling on debt (credit cards, personal loans, HELOC) to fund a lavish lifestyle without a proper plan in place to pay it back ASAP, you can get into serious financial trouble.
- You can lose the roof over your head: Following from the point above, you can literally lose your home if you’re unable to make payments on your loan when required. Life happens…loss of a job, accidents, divorce, market crashes, etc. The lower your debts, the easier it may be to weather the storm.
- Interest rates may rise: Interest rates on your HELOC can change – increase or decrease depending on market conditions. If rates rise significantly, it may impact your ability to pay down your debt.
Depending on what your plans or circumstances are, a HELOC can be a great financial tool. However, properly assess your finances and intentions before proceeding to apply for a HELOC (and any loan for that matter!). You should probably not be applying for a HELOC to finance day to day necessities, unnecessary purchases/luxuries, and if you are drowning in other consumer debt (unless it’s part of a well thought-out debt consolidation and repayment plan).