A Primer on HELOCs

home-equity-line-of-creditThis is a guest post by the experts at Ratehub.ca

When you need money to consolidate debt or renovate debt, sometimes a home equity line of credit (HELOC) can come in handy.

A HELOC is a loan that’s secured by the equity in your home. The equity refers to the value of a home after subtracting the value of the mortgage. For example, if your home has a market value of $500,000 and you have a $200,000 mortgage, you have $300,000 in equity.

How a home equity line of credit works

In Canada, the maximum amount for a HELOC is 65% of the total value of a home. Furthermore, the value of a HELOC—when added to the current outstanding mortgage balance—cannot exceed 80% of the market value of the home.

Here’s how this looks using some figures. Let’s assume that the market value of a home is $500,000, and the outstanding mortgage balance is $200,000. We first multiply the market value by 80% ($500,000 x 80% = $400,000). Now we subtract the current mortgage balance of $200,000 ($400,000 – $200,000 = $200,000). This leaves us with $200,000 in equity that can be accessed through a home equity line of credit.

After you’ve applied and are approved a home equity line of credit by your financial institution, you don’t need to access all the money at once. Going back to the example above, if you get a $200,000 HELOC, you can tap into whatever portion of the amount you’d like. Perhaps you only borrow $20,000 initially, thereby leaving $180,000 untapped, but still available to you.

A HELOC is a kind of revolving line of credit, similar to a credit card. With a revolving credit line, once you’ve paid back a portion of it, you’re then free to tap it again for more money. Let’s say you borrow $20,000 from the HELOC and then repay the $20,000 plus any interest. At this point, your available balance is once again $20,000.

Interest rates

HELOC mortgage rates tend to be much lower than an unsecured loan. As of Nov. 17, the best HELOC rate in Canada is 3.20% (check RateHub.ca for the best mortgage rates on non-HELOC loans). HELOC rates are slightly higher than those for a variable-rate mortgages but they’re still very low. Banks are willing to lend at lower rates because they know your home is being used as collateral.

Typically, the interest rate on a HELOC is expressed as the prime rate plus a specific number (for example, 2.7% plus 0.5%). Prime refers to the rate that banks lend to their customers. Note, that the bank may adjust the prime rate at any time.

Payments

With a standard mortgage, your payments include both principal and interest (for example, you’re paying back what you borrowed as well as interest at the same time). Home equity lines of credit, on the other hand, have interest-only payment structures. This means that you will have to make extra payments over time to reduce the amount you borrowed.

Avoid temptation

On the one hand, tapping into your home’s equity can be a ready source of significant cash. This is tempting if you need to pay for a renovation or even something unrelated to your home. That said, if you’re considering getting a HELOC, make sure you use it wisely and for the right reasons.

It’s not advisable, for example, to borrow a huge amount for something you don’t need. In other words, just because you want to take a vacation somewhere, you probably don’t want to borrow against your home’s equity to do so.

Second, keep in mind that real estate values fluctuate. This is a crucial consideration with HELOCs. Say you obtain a large HELOC when the market is hot (in which case you’ll likely have significant equity). In the event that the market takes a tumble, the equity in your house will fall, but you’ll still owe the money to the bank. That’s not a great situation to find yourself in. So if you do decide to get a HELOC, try to borrow conservatively. Just because you’re able borrow a large amount of equity doesn’t mean you should.

Note: One of our moneyproblems.ca advisors has a podcast on Nov 30, 2016 mortgage updates. Some of these updates affect the ease of attaining a HELOC. Listen to the full podcast here.

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