Illustration by Melanie Lambrick
If you’re about to take out a mortgage, your financial institution might also offer you the opportunity to open up a home equity line of credit alongside it. These lines of credit, which can be set up when you buy your house or any time you own a home, function a little differently than other lines of credit and credit products. Here’s a primer on how HELOCs work, with insights from personal finance experts on their benefits and risks.
What is a home equity line of credit?
A home equity line of credit, or HELOC, is a line of credit that allows you to use the equity in your home to borrow money. It’s a secured line of credit, which means the lender uses your home as a guarantee that you’ll eventually pay the funds back.
With a HELOC you can borrow up to 65 per cent of your home’s purchase price or appraised value on a revolving basis, meaning you can borrow and repay and borrow again without having to reapply. Lenders tend to offer a HELOC at the time you take out a mortgage. Your HELOC can remain open until you sell your home, at which point you’ll have to requalify for another one based on your new home’s value.
Unlike with a mortgage where you must make payments covering principal and interest, you’re only required to make monthly interest payments on your HELOC balance. HELOCs are offered at a variable interest rate only, and many are set at the Bank of Canada’s prime rate, meaning your payments can fluctuate as rates rise or fall, though your lender must provide you with notice of any changes.
According to Canada Mortgage and Housing Corp. data, 7.55 per cent of Canadians had a HELOC as of mid-2022. Canadians owed $168.5-billion in HELOC debt as of February, 2022, up 1.4 per cent (or $2.3-billion) from the year prior, according to filings with the Office of the Superintendent of Financial Institutions, or OSFI, the federal regulator that oversees banks, some credit unions, insurance and trust companies.
What are the different types of HELOCs?
There are two main types of HELOCs available to Canadians: one that is a standalone product, and one that can be combined with a mortgage.
A HELOC combined with a mortgage is also sometimes called a readvanceable mortgage or a combined loan plan, and is offered by most major financial institutions. This product combines a traditional fixed-term mortgage with a line of credit that increases in size as the borrower pays down their mortgage principal. The credit limit on the HELOC could reach a maximum 65 per cent of the value of your home – which is also known as a loan-to-value, or LTV, ratio. The entire combined loan could reach an 80-per-cent LTV ratio.
In an example offered by the Financial Consumer Agency of Canada, or FCAC, a buyer who purchases a $400,000 home and makes a down payment of $80,000 will have a mortgage balance of $320,000. Their HELOC credit limit would be fixed at $260,000 – but, at a hypothetical 4-per-cent interest rate and 25-year amortization period, the buyer would only have access to a roughly $7,600 HELOC in their first year, and wouldn’t reach the full amount until Year 24.
In June, 2022, OSFI announced plans to reduce how much homeowners can borrow against their homes through these combined loan plans, because of concerns about overleveraged borrowers. While someone with a combined loan plan can make a payment to their principal and then immediately reborrow that same amount through their HELOC, the regulator will soon only allow that option for borrowers whose LTV ratios for the entirety of their combined loan are less than 65 per cent.
Globe and Mail real estate reporter Rachelle Younglai wrote in June that while OSFI said highly leveraged combined loan plan borrowers were creating risks to Canada’s financial system, the mortgage industry expects the change would have little impact as most lenders are already limiting borrowers who reach that 65-per-cent threshold.
Separate from a readvanceable mortgage, buyers who are making at least a 20-per-cent down payment – or have at least 20-per-cent equity in their current home – have the option to split the financing of a home purchase between a fixed-term mortgage and a HELOC, giving them the ability to pay back part of their mortgage on their own schedule. The maximum portion of your home that can be financed through a HELOC is 65 per cent of its purchase price or market value.
Stand-alone HELOCs, meanwhile, are revolving credit facilities that are unconnected to your mortgage. While these products have the same credit limit of 65 per cent of your home’s purchase price or market value, they won’t increase as you pay down your mortgage principal.
It’s also possible to use a stand-alone HELOC as a substitute for a mortgage. It requires a much higher down payment, of 35 per cent or more, to qualify. The FCAC notes that buyers who use this option can pay off the principal and interest on a flexible timeline, and allows them to pay the entire balance of the mortgage at any time without incurring the prepayment penalty that’s common in many mortgages.
How can I qualify for a HELOC? Who is eligible?
In order to approve you, your lender will want to see that you have a good credit score, proof of stable and adequate income and a debt load that’s reasonable for your income. You’ll also need at least 20-per-cent equity in your home to access the credit.
HELOCs are available both to uninsured borrowers – those who make a down payment of 20 per cent or more – as well as borrowers who make a down payment of between 5 and 19 per cent and require mortgage insurance.
Uninsured borrowers can access their HELOC immediately, as they meet the equity requirements. But while insured borrowers could set up a mortgage and HELOC at the same time, they won’t have access to the line of credit right away as they don’t have the requisite level of equity in their home, says Joe Bladek, a Barrie, Ont., mortgage broker. “The home equity line of credit would only start to become available once the mortgage itself has been paid down quite considerably,” he says. “For someone going in with 5-per-cent down, this may not happen for years.”
However, he notes, there is a unique scenario where insured borrowers could access their HELOC immediately. Some lenders have insured mortgage products available for self-employed borrowers, even if they plan to make a down payment of 20 per cent or more. In this case, the HELOC would be available immediately, Mr. Bladek says.
What are the benefits of opening a HELOC?
The revolving nature of a HELOC gives you flexible access to credit without having to regularly reborrow, says Sandra Fry, a Winnipeg-based credit counsellor with the Credit Counselling Society, a nonprofit that helps Canadians manage debt. “If the water tank goes, there’s a crack in the basement, or whatever, it’s a really nice way to have that ability to access your equity without having to qualify.”
Given their lower interest rate, HELOCs are “actually a smart way to borrow in an emergency – light years better than credit cards,” Globe personal finance columnist Rob Carrick wrote in an April, 2020, column. Currently, the average credit card interest rate in Canada is 19.99 per cent, according to comparison website rates.ca. (Though low-interest cards can be as low as 4.99 per cent.)
That’s why Jason Heath, managing director at Objective Financial Partners, Inc., in Markham, Ont., recommends setting one up when you meet your bank’s credit, income and debt requirements, even if you have no immediate need for it. Banks, he says, “are more inclined to approve people who don’t need a [HELOC] and less inclined to approve people who do.”
“It can come in handy three years down the road when you have an emergency or a health issue or a job loss, and it’s harder to go to the bank and get a home equity line of credit set up at that point,” he says. “I usually encourage people to set it up when they buy a home so they have it in place.”
Mr. Heath added that getting a HELOC in place a few years ahead of your planned retirement date, if you don’t already have one, can be advantageous because it will be more difficult to qualify once you have no income. This strategy can also allow you to avoid taking out a reverse mortgage, a type of home loan for Canadians who are over 55 that allows you to access up to 55 per cent of your home equity but comes at a higher interest rate, to cover unexpected retirement expenses.
Ms. Fry notes the lower interest rate available to HELOC holders makes it an ideal vehicle for debt-consolidation; moving higher-interest debt onto the line of credit can allow you to save on interest payments and reduce your number of monthly bill payments.
According to a 2019 FCAC study that surveyed 4,800 Canadians, renovations were the most common use of the lines of credit, followed by debt consolidation, vehicle purchases, day-to-day expenses, emergency funds and vacations.
What about the risks?
While the ability to only make interest payments on a HELOC balance gives borrowers plenty of flexibility, Mr. Heath notes that can be a double-edged sword. “If you’re paying down your mortgage and adding to your line of credit, you’re going sideways on debt. It’s a bad long-term trajectory to be on in terms of someday being financially independent,” he says.
Globe personal finance columnist Bridget Casey wrote in May, 2022, that HELOCs have made Canadians “complacent with debt” and noted HELOC balances have tracked the country’s debt-to-income ratios near perfectly for the past 20 years and become “the main driver of household debt burden.” She pointed to the 2019 FCAC study that found the average HELOC balance was $65,000, and as many as 25 per cent of borrowers had a balance higher than $150,000.
According to the FCAC, if you have a balance on your line of credit, you may have to pay it off in full if you plan to switch your mortgage to another lender.
It’s also important to know that banks and other lenders have “almost unlimited power” to change the terms of your HELOC, Mr. Carrick wrote in April, 2020. He pointed to information from the FCAC that says HELOC lenders can increase your interest rate with 30 days’ notice or change the payment terms to require you to switch to a mortgage-type loan that blends interest and principal payments. They can reduce your credit limit to at or just above your current balance owing on the HELOC – or even below the current balance, forcing you to quickly repay the difference.
Lenders also have the ability to recall your HELOC and ask you to repay in full immediately if you’re behind on payments, if you experience an event that would risk your ability to pay down your balance or if your property value drops to what your lender considers an “unacceptable” level.
If you miss payments even after developing a repayment plan with your lender, you could also face the possibility that your lender repossesses your home.
How do rising interest rates affect HELOC holders?
The Bank of Canada’s series of rate hikes in 2022 have highlighted the risks of the HELOC’s variable rate. According to CMHC data, Canadians’ average monthly HELOC payment was on the rise, reaching $558 in the second quarter, up from $505 in the previous quarter. Globe reporter Ben Mussett wrote in July, 2022, that financial experts expect to see a rise in delinquency on HELOC debt in the coming months, particularly if inflation stays hot.
Mr. Heath said Canadians who’ve been using their home equity line of credit for consumer spending and “living beyond one’s means” are likely to be hardest hit by these rate hikes. “If somebody finds they are frequently tapping their HELOC for monthly spending, that can be a bit of a red flag. … With interest rates rising and home prices falling, a lot of people are going to hopefully step back and say, ‘My home equity is not income, it is not something I can use to pay for my day-to-day living expenses.’”
However, he noted, some lenders may allow a borrower to add some of their HELOC balance to their mortgage, which locks the debt in at a set interest rate and forces the borrower to make a fixed monthly principal and interest payment, rather than just interest only.