One of the nicest things about homeownership – aside from having a roof over your head – is that every month that you make your mortgage payments you build up equity in the property. Build up enough equity and you can consider withdrawing some of it in a home equity line of credit (HELOC) to fund renovations or make some other form on investment.
Here are some of the advantages – and potential dangers – of tapping into your equity.
What is a HELOC?
A home equity line of credit (HELOC) is a loan that’s based on the amount of equity you own in your home. In the past, banks could offer you as much 80% of the loan-to-value ratio of your property, minus the remaining balance you owe on your mortgage. However, recent changes to Canada’s banking regulations have reduced that amount to 65%.
Say, for example, your house has an appraised value of $400,000. Sixty-five per cent of that is $260,000. If you owe $200,000 on your mortgage, you would qualify for a $60,000 HELOC. While the rate on a HELOC is better than a regular LOC, it’s often higher than your mortgage rate. So if you do pay down that conventional mortgage and yet keep borrowing, you will end up spending more long term.
How to apply for a HELOC?
The application process is similar to that of a mortgage: you’ll be required to supply income and tax statements, the financial institution will conduct a credit check on you and any co-applicant, and they’ll likely require a professional home appraisal to determine an accurate value of the property. (In order to get your business, most banks will cover the cost of the appraisal.)
What can a HELOC be used for?
It's a very flexible loan. Once you’ve been approved for a HELOC, you can use the money for whatever you want – home renovations, seed money to start a business, or tuition for yourself or your children. It can also be a useful tool for consolidating other high-interest debts.
There’s no incentive for paying off a HELOC. Its up to you and your own self-discipline. Unlike a traditional loan, you don’t get all the money upfront (and, therefore, don’t start paying interest on the loan amount right away). A HELOC is more akin to a debit account that you withdraw from as needed. This makes it a very practical financing option for major home renovations where you’ll have ongoing expenses staggered over several months.
HELOC loans are also open-ended, meaning that once you qualify for a HELOC, you can access any remaining loan amount for as long as you have the mortgage. So once you’ve paid off the renovation expenses you incurred on your HELOC, that money will be available down the road if you have, say, a short-term budget shortfall.
How to pay your HELOC back
While your bank will automatically withdraw any interest you owe on your HELOC every month, you can make principle payments any time you like. You can call the bank to get on a regular monthly payment program, or transfer money over any time you have spare cash. If your bank has a good web portal, moving money around on your HELOC is easy.
Obviously, HELOC money doesn’t come for free.
For one, there will be a relatively modest admin fee to process an application. You may also be required to pay for a home appraisal, and you’ll need to have a real estate lawyer review the loan documents.
Although you don’t start incurring interest until you withdraw funds from a HELOC, the interest rate is a variable one that’s tied to the lending institution’s prime rate. As interest rates rise – as they’re sure to eventually start doing – the cost of carrying any outstanding loan amount will increase with it.
But the real danger is when people treat HELOCs as bank accounts they can withdraw from whenever the mood strikes, using the money to fund vacations or other unnecessary purchases. If the real estate market drops and you’ve built up too much HELOC debt, you could find yourself “under water” – with a house worth less than you owe on it.
This happened on a massive scale with the recent U.S. housing market crisis, with countless thousands of people simply walking away from homes they could no longer afford.
Top HELOC tips
- Be cautious if your bank offers you a sky-high HELOC. Borrow only as much as you need.
- Try to do renovations, travel and other big purchases from savings, not a HELOC.
- As soon as you draw down on your credit line, call the bank to set yourself up on a payment program of at least a few hundred dollars a month.
- Avoid making extra payments on your conventional mortgage. Instead, put that money toward your HELOC.
- Keep an eye on how much interest you are paying each month. Put that amount (and your principal payment) into your monthly budget.
- When making long-term plans regarding paying off your mortgage, take the amount you owe on your HELOC into account.