If you are renewing a mortgage in 2023, you are probably already taking a hard look at your finances and identifying ways to cut costs.
In 2022, the Bank of Canada’s interest rate rose from a historic low of 0.25% to 4.25% over a nine-month period. Canadians also continue to feel the pinch from high inflation. Many are looking to tighten the proverbial belt in 2023. Specifically, folks are looking at ways to pay down debt to minimize extra borrowing costs while interest rates remain higher.
An option you may want to consider, particularly if you have unsecured debt, is a home equity line of credit (HELOC). A HELOC may be a good option to consolidate other household debt since it typically offers a lower interest rate than most standard lines of credit, loans, or credit cards.
What is a home equity line of credit (HELOC)?
A HELOC is similar to a traditional line of credit in that it is revolving credit up to a maximum credit limit – you can borrow money, pay it off, and then borrow it again. The key difference is that it is secured credit. The lender uses your home as collateral ‘security’ to ensure they can collect what you owe, if necessary. The reduced risk associated with secured credit means that lenders can typically offer lower interest rates on HELOCs, sometimes as low as prime plus 0-1%.
What’s the difference between a HELOC and a readvanceable mortgage?
There are two main types of home equity lines of credit. A standalone secured line of credit, and a line of credit that is combined with a mortgage.
Standalone home equity line of credit
A standalone HELOC is a revolving credit product that is guaranteed or secured by your home. It is not related to your mortgage.
The maximum credit limit on a standalone HELOC is up to 65% of your home’s purchase price or market value. The credit limit does not increase as you pay down your mortgage principal.
Readvanceable mortgage
While different financial institutions may offer slightly different variations, generally speaking a readvanceable mortgage combines a revolving HELOC and a fixed-term mortgage. Typically interest is paid only on the amounts borrowed under the HELOC, while the fixed term mortgage will have regular, scheduled payments on both the principal and interest over an amortization period.
The credit limit on a home equity line of credit combined with a mortgage can be a maximum of 65% of your home’s purchase price or market value. The amount of credit available in the home equity line of credit will go up to that credit limit as you pay down the principal on your mortgage.
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Benefits of a HELOC
In addition to typically offering lower interest rates than unsecured forms of credit, HELOCs can offer homeowners greater borrowing flexibility.
For example, you can use a home equity line of credit combined with a mortgage to buy a home. In order to do this, you need a 20% down payment or 20% equity in your home. Of the remaining 80% of the home’s purchase price or market value, up to 65% can be financed with the HELOC while the remaining amount must be on a fixed term mortgage.
For example, if you purchase a home for $500,000, the required down payment is 20% ($100,000) which leaves a remaining mortgage balance of $400,000. You can finance a maximum of $325,000 with your HELOC which leaves $75,000 ($400,000 - $325,000) that needs to be financed with a fixed-term mortgage. Using a HELOC this way provides more flexibility without a fixed payment schedule or prepayment penalty.
And if you have at least 35% to put down as a down payment, you can actually use a HELOC as a substitute for a mortgage. Something to keep in mind, of course, is that HELOC interest rates are variable and will fluctuate based on changes to the prime lending rate.
Considerations before getting a HELOC
In order to qualify and be approved for a HELOC you need:
- A minimum down payment or equity of 20%, or
- A minimum down payment or equity of 35% if you want to use a stand-alone home equity line of credit as a substitute for a mortgage
- A credit check
- Proof of income
- Acceptable debt-to-income ratio
- To pass a “stress test” whereby you can afford payments at a qualifying interest rate, which will generally be the interest rate you negotiate with your lender plus 2%
There are typically some additional costs associated with HELOCs that may include:
- Home appraisal or valuation fees: Your lender charges this fee to send someone to assess your home’s value
- Legal fees: A lawyer, notary, or title service company charges this fee to register the collateral charge on your home
- Title search fees: This is another legal fee to ensure there are no liens on your home
- Administration fees: Your lender charges this fee for setting up and maintaining your account
- Credit insurance fees: also known as premiums for optional life, critical illness, disability and job loss insurance
- Discharge or cancellation fees: A lender or notary charges this fee if you cancel your home equity line of credit and remove the collateral charge from the title of your home
With the added flexibility that a HELOC provides, it’s critically important to exercise restraint and discipline so that you remain in control of your debt. When used appropriately, a HELOC is simply another tool available to you to help ensure you have the funds you need, when you need them. But this does come with the added risk of losing your home should things get out of control.
If you have questions about setting up a HELOC or renewing your mortgage, Wally can connect you with his trusted network of brokers and lenders who can walk you through the best options.
With over 20 years of Edmonton real estate experience, Wally has helped hundreds of homeowners navigate the home buying and selling process. Call/text Wally at 780.238.7384 to learn more.