Home equity lines of credit (HELOCs) have gotten some attention with the recent changes in mortgage rules. A HELOC is essentially a mortgage loan that allows the borrower to take multiple advances of the loan proceeds at his or her convenience. The interest rate fluctuates with the Prime Lending Rate and the interest is accrued on an average daily balance. Payments are interest only and your home is the lender’s collateral if you do not pay. Historically, you can set up a HELOC for 80% of the value of your home. In the near future, you will be limited to 65% of the value of your home. Like all financial tools, the HELOC is something that may or may not be a fit for you. Below is a guide to the best uses for a HELOC, the pitfalls, and how you can tell if you’re using yours correctly.
Ideal Uses for a HELOC
Investment Purposes - In Canada a loan for investment purposes is tax deductible. This includes interest on a HELOC being used solely for investing. For example, you pull out equity at 3.5% and make 7.5% return on an investment income. For the right individual, this can be a great way to grow investments and increase interest income.
Pre-Retirement Planning - Access to financing of any sort is difficult once you are on a pension or retirement income. Financing is approved based on income, not total assets or net worth. This is why reverse mortgages have become more and more prominent. A HELOC can be set up on your property for the cost of an appraisal and legal fees and it is then accessible at any time. With the amount of net worth Canadians have tied up in real estate equity, this liquidity allows you to take advantage of that equity. For example, if one day you need to downsize or move rapidly due to health reasons, having access to equity in your current home allows you to purchase your next property without having to sell your current property first
Second Property Purchase - A HELOC on your prime residence can be a simple way to get the necessary funds for a recreational property or real estate investment, particularly US and other international properties.
Children’s Education - Using a HELOC can be a great option to finance your children’s education costs. It allows you to pay the tuition at the start of the year and make monthly payments to pay it off before the next school year at a low finance and interest charges. For example, taking out $5000 on your HELOC to cover tuition will cost $175 for the year in interest* and if you make monthly payments of $431.25 it is paid off before the next school year.
Low Interest Financing on Planned Purchases - A HELOC can also be a cheaper option to financing a larger purchase such as a vehicle or home renovation. Make sure you have a plan to pay off the balance and that the purchase is for an asset or increases the value of your home (not all home renovations actually increase the value of your home).
Debt Consolidation - If you have a large amount of credit card debt or other high interest debt, debt consolidation onto a HELOC is one option to reduce your interest costs, allowing you to pay down the balances faster. Again, this only works if you have a plan to pay down the balance.
It is important to fully understand the impact of taking on a HELOC and the pitfalls associated with them:
May Impact Your Credit Rating or Access to Future Credit - A HELOC will show up on your credit bureau and can impact your credit rating and future access to credit, particularly if you have borrowed up to or near your HELOC limit.
No Set Pay-Off Plan - A HELOC is structured with interest only payments, which greatly reduces the motivation to pay down the balance.
Reduced Ability to Switch Lenders - HELOC’s are registered as a collateral mortgage and so they can’t be transferred to another lender for a lower cost without fees associated. A HELOC marries you to your lender.
Too Easy - The greatest benefit of a HELOC, flexibility, is also its biggest downfall. If you generally find it easy to rack up debt or tend to buy on impulse, a HELOC is not for you.
Floating Interest Rate - Unlike a fixed mortgage, the interest on a HELOC fluctuates with the Prime Lending Rate. Before putting a large balance on your HELOC, double the interest charges and make sure you can still afford it. If interest rates rise, you want to be able to still afford the payments and be able to pay it off, without risk of losing your home.
Callable and No Rate Commitment - If you read the fine print on a HELOC, they are all technically callable (the lender can demand the balance in full) and the rate can be changed by the lender at any time (ex. prime + 0.5% to prime + 1.0%). While this is very uncommon, it is possible.