If you’ve been hearing that Home Equity Line of Credit (HELOC) is the greatest thing ever, it’s because banks love them. There are three things that lenders count on when they offer you a home equity line of credit.
- You will pay interest for a very long time.
- Your house will remain a valuable asset.
- You don’t want to lose your home.
The most valuable asset many Canadians have is their house. A HELOC provides access to that value. The money is there when you need it; you can take some now, take some later and make manageable interest-only payments for years. The funds can be used to pay off your credit card bills, replace those worn snow tires, and have plenty of money left over… in case you need it someday.
So banks lend and homeowners take. It’s nearly risk free for the lender. After all, the transaction is secured by your home. But how much risk do you incur? Here are some considerations to keep in mind before you sign on the dotted line.
Why HELOCS Are Growing in Popularity
Financial advisors acknowledge that in addition to providing a place to live, your home is a pretty good way to accumulate wealth. And that’s a good thing. The equity is just sitting there. Why not use it? You have a lifetime to pay it back.
The equity in your home is the difference between the amount you owe and your home’s market value. Equity increases as you pay down your mortgage and as the real estate prices go up. The housing market has been in a general upward trend since 2002. So when the bank offers you access to a wad of cash based on the equity you’ve built, why not take it?
The average HELOC balance in Canada is $70,000 with a generous average limit of $168,000. This figure is for all of Canada. In provinces where home values aren’t as high, for example, in New Brunswick or Prince Edward Island, the average amount may be lower.
How a HELOC Works
With a HELOC, you can borrow up to 80% of your home value minus the mortgage balance. So, for example, if your home is worth $350,000, 80 percent of the value is $280,000. With a mortgage balance of $225,000, you can borrow up to $55,000.
If you are using a HELOC to make improvements and increase the market value of your house, it’s not a bad idea. In fact, that was the original purpose of HELOCs. Today, that’s changed. HELOCs are used for debt consolidation, college tuition, emergency expenses, elaborate vacations, and a host of other purposes.
HELOCs may seem like easy money. But there are risks associated with these financial products that may not be immediately apparent. When you take a HELOC, you tap into the value that you have accumulated in your house. It’s your asset, after all. But here’s a more pragmatic way to think about it.
Let’s say you purchased your home at fair market value for $350,000. You then borrow $35,000 on a HELOC. It’s really not much different than paying $385,000 for your home. That may not seem like such a big deal as long as the real estate market is hot. But remember, there are no guarantees that housing prices will continue to climb.
Also, remember that a HELOC is non-mortgage debt. In general, mortgage debt builds equity. Non-mortgage debt is just debt.
How to Get a HELOC
To qualify for a HELOC, lenders may require 20 percent equity in your home and a decent credit score. Although lenders consider HELOCs low risk, you still must prove adequate income and have a history of timely bill payment. Once approved, you can draw down as much as you like whenever you want up to the total approved amount.
Many HELOCs allow you to make interest-only payments for many years before you must start paying down the principal. Roughly 27 percent of Canadians do just that.
HELOCs are attractive because the interest rate is lower than a home equity loan and much lower than a credit card. All you need is an account card and you can use your line of credit as conveniently as your Visa. Plus, HELOC rates are calculated every six months rather than daily. This makes a big difference in how much you’ll repay in the long run. In comparison to sky high credit card interest rates, the HELOC shines.
HELOCs: The Dark Side
Remember that the HELOC is in addition to unsecured debt. Unlike your other credit cards, however, a HELOC is like a giant credit card attached to your house. Many homeowners intend to use the proceeds to pay off their credit card balances. In reality, though, homeowners tend to carry higher levels of unsecured debt than renters. That’s due in part to lenders qualifying them for more credit believing that they are not as risky.
A HELOC gives homeowners access to a tempting pile of easily-accessed money with convenient low payments, in some cases for up to 10 years. But that’s not where the story ends. There are four critical considerations that you should understand before you take a HELOC:
- The bank can modify the terms.
HELOCs have certain terms and conditions that allow the bank to make various changes. The interest rate is tied to the Bank of Canada and will float above that rate. Your HELOC lender can change the interest rate at any time. But they may also make changes that have nothing to do with the bank rate.
Lenders can and do perform periodic credit checks on borrowers. This may tell them that your credit score has changed, you’re struggling with payments, or that your debt level is increasing.
If this happens, they can require principal repayments earlier than expected. A typical demand may be that you pay down the principal at one percent per month in addition to your interest payment. On a $35,000 outstanding balance, that’s a $350 a month unexpected expense.
- Your circumstances can change.
Zolo estimates that the average Canadian changes homes about 5 times. These days, people do not stay put for a lifetime. They may need to or want to move for job opportunities, a different school district, a bigger yard, or because they’ve outgrown the old house.
Economic circumstances may change, as well. You can’t always predict health or elder care issues or job losses, for example. You may be unprepared for your children to enter college or the financial hardships that drive adult offspring back home.
As mentioned, the interest rate on your line of credit may increase. Typically, Interest rates will increase, as well, on your unsecured debt. These factors could further increase your reliance on credit, particularly if your budget is already tight.
- The real estate market may correct.
Over nearly two decades, there have only been two brief periods of real estate decline, in 2008 and 2017. Some economists believe that these unprecedented increases over recent years reflect inflated housing values.
This upward trend cannot continue forever. Fortunately, the bank doesn’t really want your house. As long as you continue to make your HELOC and mortgage payments, all is well. But what if you need to sell for a great opportunity in a new city? If you are underwater on your mortgage, i.e., owing more than the home is worth, you could be stuck.
- There is no real plan to get out of debt.
A mortgage is amortized over a period of time. This means that if you follow the payment schedule, you will get out of debt. With a HELOC, there may be no end game. You take out a $20,000 HELOC in 2012, make payments for nine years, and in 2021, you still owe $20,000. You can delay making principal payments indefinitely by reopening the line of credit. In that case, you’ll continue to make interest-only payments.
What Can You Do Besides HELOC?
A HELOC can look like a good option if you have too much credit card debt. But the important thing to remember is that you are exchanging unsecured debt for secured debt. A HELOC is a large revolving debt secured by your house. It’s easy to borrow more than you intended and find yourself even more vulnerable to financial trouble.
Before you make any moves that change your financial security, speak to a Licensed Insolvency Trustee. LITs are the only people licensed by the Canadian government to seek a legal debt remedy on your behalf.
Remember, however, that your choices do not come down to HELOC or Bankruptcy. There are other options you may not have considered. A Consumer Proposal, for example, could significantly reduce your level of debt and help you avoid Bankruptcy.
If you are struggling with unsecured debt and don’t have a solution, call the professionals at Allan Marshall & Associates at 1-888-371-8900. The initial consultation is free and the advice invaluable.