Answering Five Common Questions About HELOCs

What is a HELOC and how does it work?

If you’re a homeowner and need to borrow money, you’ll probably know about some of your options to borrow money from your home: a home equity loan, a second mortgage, refinancing or a regular loan. But there’s another alternative – a Home Equity Line of Credit (HELOC). A HELOC is not a loan for a fixed amount; it’s a line of credit (LOC), a pool of cash that you can dip into as you need. Since your home will act as collateral, this line of credit offers a lower interest rate than other lines of credit. The credit limit of the home equity line of credit is based on the equity you have in your home [1].

You can choose from two kinds of HELOCs: one HELOC is combined with a mortgage and the other HELOC is stand-alone [1]. The first kind involves a revolving line of credit and a fixed term mortgage. You have to make regular payments of interest + principal on the mortgage but you only need to pay the interest on the HELOC if and when you dip into it. The stand-alone HELOC isn’t related to your mortgage and you need only pay interest on the funds you use when you use them. In both types of HELOC, you can pay off the HELOC principal when you want to and not necessarily on a regular schedule [1]. 

Your HELOC will have a variable rate interest consisting of the prime bank rate plus a premium. However, sometimes the HELOC rate could be even lower than the banks’ prime rate. As of January 2020, the HELOC rate for most banks is between prime-0.2% to prime+0.5% where prime is 3.95% [2].

The maximum amount of your HELOC depends on your equity in your home. Your home equity is the current value of the property minus the amount left on your mortgage. The maximum credit for the HELOC in both options is 65% of your home’s market value. However, with the HELOC plus mortgage option, you can use a maximum of 80% of your home’s value with a maximum of 65% in the HELOC and a minimum of 15% on the mortgage. For example, for a $500,000 home with $300,000 left on the mortgage, the HELOC amount is $100,000 [3]. Calculate your maximum HELOC amount here.

Is getting a HELOC a good idea? 

A HELOC can be used for anything you want – a nice vacation, a new car or more furniture for example. The best use, however, is one that generates value, such as home renovations, or covers long-term ongoing expenses including college tuition and medical bills. With home renovations and remodelling, you’re borrowing money against your home to improve the home’s value. This use for a HELOC can give you a return for your investment in your home at a higher rate than the HELOC interest rate [4] especially if you have a plan to sell your home soon. 

A HELOC can also act as an emergency fund. You don’t pay interest until you borrow from it, so it can just sit there. However, there’s always the temptation to dig into the HELOC to finance a lifestyle that your income alone can’t support.

Additionally, remember that you have to make monthly interest payments when you take funds from your HELOC. On the other hand, you can pay off the principal whenever you want without penalty, useful for those who have an uneven income [1]. 

As with other loans, some downsides are: your lender can demand that you pay the full amount outstanding at any time, rising interest rates will increase your monthly interest payment since the HELOC rate is variable, and the lender can change your credit limit at any time [1].

Overall, a HELOC is a good idea if you’re financially disciplined, plan to use the money to improve an existing asset and stick to a repayment schedule.

How do I get a HELOC?

The best advice is to shop around with your local financial institutions. You will typically need a home equity share of at least 20%, or if you want to use a HELOC without having a mortgage in which case you need equity of 35% [1]. The lender may decide to appraise your home to determine its market value.

Your minimum credit score may vary with the lender, but your debt-to-income ratio usually needs to within 45%-50% or lower [1]. 

You must also pass a mortgage stress test. This test helps to make sure that you’ll be able to make your payments if the interest rate rises. The new interest rate used in the stress test calculation is the greater of your offered mortgage rate + 2% or the Bank of Canada stress test rate (5.19% as of January 20, 2020) [5].

What are the main differences between a HELOC and a 2nd mortgage?

Both a HELOC and a second mortgage raise funds using your home as collateral. However, HELOC credit is at a variable interest rate while your 2nd mortgage can be at a fixed rate that is usually higher than HELOC but you will be able to access more of your home equity.

Your HELOC can be with the lender of your first mortgage who probably knows you well. Your 2nd mortgage is usually with a different lender (typically not an A lender) so you’ll have to shop around for the best available terms.

The amount that you can borrow is also different between a HELOC and a 2nd mortgage. With a HELOC you can borrow up to 65% of your home’s value while a 2nd mortgage gives you access to up to 95% of the value of the home [6].

What are the main differences between a HELOC and refinancing the 1st mortgage?

You can withdraw money from a home using a stand-alone HELOC instead of a mortgage. A HELOC provides more flexibility than a mortgage. Aside from the monthly interest payments, you can choose when to pay off the rest of the interest and the principal, paying down your principle only when you have the additional funds to do so. Mortgage interest rates are usually lower than HELOC rates so if you need a significant amount of money for a project that you most probably can’t pay back in the future soon, refinancing might be a better option

For HELOC, the interest rate is variable so unlike the fixed payments in a fixed-rate mortgage, if the interest rate rises, so do your HELOC interest payments. The rates are also higher than the rate of the initial mortgage. For example, as of January 20, 2020, the best 5-year fixed mortgage rate was 2.6% while the best HELOC rate was 3.75% [2]. You can use WOWA’s HELOC Rates to find the best HELOC rates currently available.

You do have the option of combining a HELOC and a mortgage for the best of both worlds. The mortgage part of the combo requires the usual regular interest + principal payments but the HELOC part gives you the flexibility of when to pay down the HELOC principal amount you take out. The major Canadian banks have this option but they each use a different name for it; for example, RBC has the Homeline Plan.

The bottom line

The revolving line of credit of a HELOC, guaranteed by your home, is an alternative source of funds compared to a home equity loan, second mortgage, or refinancing. If you have a value-generating project to fund and are financially disciplined, then a HELOC might be the right choice for you – but always shop around for the best rates and terms.


Sources

  1. Getting a Home Equity Line of Credit. Government of Canada 
  2. Best HELOC Rate. RateSpy HELOC Rate
  3. HELOC: Home Equity Line of Credit Calculator 2020. Wowa.
  4. Understanding the Difference between Home Equity Lines of Credit and Home Equity Loans. Nationwide.
  5. Daily Digest. Bank of Canada.
  6. HELOC vs Mortgage: Everything you need to know. CMI.
  7. Mortgage Rates. The Royal Bank of Canada.

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1 Response

  1. vurtilopmer says:

    I couldn’t resist commenting

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