There are approximately 3 million HELOC accounts in Canada with an average outstanding balance of $70,000—and many Canadians with a HELOC can expect their borrowing cost to increase this year with rising interest rates looming.
Mortgages, on the other hand, are obviously much more widely used in Canada than HELOCs. But, there are many situations where a HELOC may be better than a standard mortgage.
Let’s take a closer look.
HELOCs: An introduction
A HELOC stands for Home Equity Line of Credit, and is a financial product that allows you to borrow against the equity you currently hold in a real estate asset you own—such as your primary residence.
HELOCs are growing in popularity amongst Canadians each year. Consumers can use as much or as little as they need, as long as they stay within their credit limit and keep their account in good standing. The repayment terms on HELOCs are flexible allowing borrowers to make interest-only payments outstanding balance.
Additionally, unlike with mortgages, borrowers may also reduce their principal with multiple lump-sum payments made at their discretion, without having to worry about incurring prepayment penalties.
Like mortgages, most HELOCs are not amortized and do not have a maturity date. Provided borrowers keep their account in good standing and stay within their credit limit; borrowers can draw on and repay their HELOC over an indefinite period. They are more flexible borrowing option when compared to a typical mortgage.
HELOCs and credit cards both have variable interest rates, and they allow lenders to raise those rates at their discretion. Since a HELOC is secured by a borrower’s home, they are considered low-risk products, and lenders typically offer them at more attractive interest rates compared to your standard conventional mortgage provided at a fixed rate. Borrowers can generally acquire a HELOC for the lender’s prime rate plus a premium of between 0.5 and 2%. The interest rates rise when the prime rate goes up.
How interest rates work for HELOCs
The prime rate typically moves in tandem with the Bank of Canada’s key interest rate. When the Bank of Canada raises rates, the big banks raise their prime rates in turn. Most banks in Canada have the same prime rate. To provide some context, the Bank of Canada has increased its key rate to 1.25% from 0.5% from a year before. To put that figure into the perspective of the borrower, a rate increase of 0.75% translates into an increase of 23% on a HELOC with an interest rate of 3.2%.
For homeowners with a significant portion of their home paid off and access to ample equity, a rise in interest rates can be more comfortably cushioned compared to homeowners who are living pay cheque to pay cheque. According to a study by Mortgage Professionals Canada, over 1.5 million Canadians have a mortgage and a HELOC while approximately 490,000 Canadians have a HELOC and no mortgage.
Lenders typically offer a conventional mortgage in two types of rates – fixed and variable. Most Canadians go with a fixed rate mortgage as it makes it easier to budget for payments with an interest rate that is guaranteed for the lifespan of that mortgage. With a HELOC, it is essential to read the fine print to understand what the notice period is for potential rate increases by the lender.
Borrowing limits with HELOC loans
Regarding how much you can borrow, the Canadian government regulations stipulate that a HELOC combined with a mortgage cannot exceed 65% Loan to Value (LTV) unless it is in second position.
If the HELOC is secured on your home in second position, then the amount is raised to 80% LTV. The amount of credit available in your home can go up as you pay down the principal on your mortgage.
Additionally, the LTV percentage can increase if the value of your home increases with the support of a healthy market prompting your home to appreciate in value. Both of these factors can provide additional access to credit.
Being a financially responsible borrower
With the relatively low-interest rates and flexible access to credit, some consumers find it difficult to manage their finances and bring about a cost burden that they cannot cope with.
It is a tempting proposition to less financially disciplined borrowers and research indicates that roughly 4 in 10 borrowers do not make regular payments on their HELOC loans. And, 1 in 4 borrowers only manage to cover the interest on the loan.
While the majority of consumers are fiscally responsible, it is a slippery slope for some borrowers that could bring them down a path of insurmountable debt with further research conducted by by the Chartered Professional Accountants of Canada supports this theory.
With interest rates at the mercy of market fluctuations, Canadians are most vulnerable to market corrections. They can easily find themselves underwater when their home is worth less than the outstanding loan (negative equity). This, however, goes for both mortgages and HELOCs.
As indicated in the above chart, Canadian households owed about $1.07 of disposable income in the year 2000. That ratio of debt to disposable income had risen to $1.60 by 2010. That upward trend appears to be levelling off over the last five years but is still gradually continuing its upward trend. One factor to take into consideration is that many consumers are using HELOCs to consolidate other higher-cost forms of debt like credit cards.
Most HELOC borrowers susceptible to financial strain carry large amounts of credit at variable interest rates and are prone to having their disposable income consumed by servicing these debt obligations. They are vulnerable to what is known as payment shock where interest rates rise and they are confronted with increased payments that strain their available cash flow. It is important to budget and plan your finances to budget for any future rate increases.
The right financial instrument with the right financial strategy
When considering a HELOC vs. mortgage, a HELOC can have many advantages if paired with the right strategy and financial goals. For example, if you plan on purchasing an investment property for a short period of time with plans to sell within a few years, then a HELOC would fit this strategy better with its flexible and open terms.
However, if you are planning on purchasing your first home and plan on placing as little down payment as possible, then a conventional or high ratio mortgage may be more suitable for you.
A HELOC has many advantages, but there is no clear winner in the battle of HELOC vs. mortgage simply because each financial instrument needs to be matched to your personal financial needs. This is where a mortgage professional that has experience in this arena can provide you with the right product recommendation to accommodate your financial situation.