What to Know Before Using a Home Equity Line of Credit or Loan
by Kelly Gabriel
Equity is the difference between what you own and what you owe on your home’s value. Two common ways to borrow money from your home equity are a home equity loan and home equity line of credit (HELOC). With Canadian interest rates still low and property values stable or on the rise, borrowing money from the equity in your home can be an attractive financing choice for debt consolidation, renovations, starting a business, or helping family.
Home equity loans and HELOCs are favoured by financial institutions because if you’re unable to repay what you borrowed, they have your property as security. Consumers especially like credit lines because they can draw money from them anytime at a much lower interest rate than credit cards. Minimum payments on a HELOC are also low and as someone pays down what they owe, funds become available again to them up to a set limit. The favourable line of credit interest rates, coupled with revolving access to credit and the freedom to draw large amounts at will, have made HELOCs a popular way to borrow.
Is a HELOC or Home Equity Loan Right for Me?
A line of credit or one-time equity loan can be used for anything from home renovations to big ticket purchases. How much you spend and what you spend it on are entirely up to you. As such, having a home equity credit line can be a terrific financial tool if you’re disciplined and diligently stick to a payment plan. However, for a lot of people, having a line of credit can be a means of getting – and staying – in debt.
Before you take out a home equity credit line (HELOC) or loan, here are some things to keep in mind to figure out if it’s right for you:
Mortgage, Home Equity Loan, and Home Equity Line of Credit
What’s the Difference?
HELOCs, home equity loans, and mortgages all use your home as security for the debt. All 3 can also be used to consolidate debt. But that’s where the similarities end.
What's a Mortgage?
A mortgage is a loan specifically to buy real estate. The mortgage uses the real estate as collateral for the loan, meaning that if the borrower doesn’t repay the loan, the lender has the legal right to seize the property. Like any loan, interest is charged on top of the principal, and each mortgage payment normally combines repaying the principal plus its interest.
What's a Home Equity Loan?
A home equity loan, also known as a second mortgage, allows homeowners to borrow money against the equity in their home. The loan comes as a one-time lump sum and how you use it is up to you. For example, it can pay for home renovations, medical bills, or college tuition. Like a mortgage, your home is collateral for the loan, and it will be repaid over a set amount of time. The interest rate can be fixed or variable depending on how your lender structures the loan and what you agree to.
What's a Home Equity Credit Line or Home Equity Line of Credit (HELOC)?
Like a home equity loan, a home equity line of credit (HELOC) is a loan that uses the equity in your home as collateral. However, this loan takes the form of a revolving line of credit instead of a lump sum. This kind of credit line offers greater flexibility because you have access to a pool of funds, and again, how you use it is up to you. It could help you for emergencies, debt consolidation, a home improvement project, or even day-to-day spending.
Payments toward your line of credit are flexible as well. Depending on your loan agreement, you can pay as little as just the interest on a HELOC, meaning that you don’t have a deadline on paying back what you actually borrowed. Lines of credit also come with variable interest rates that are much lower than the interest rates on credit cards.
Credit lines are like credit cards in that you only pay interest and make payments on what you use. For example, if you’re approved for a $25,000 HELOC but only borrow $5,000, then you’ll only need to pay interest on that $5,000.
How Revolving Lines of Credit Work
Both credit cards and lines of credit are excellent examples of revolving credit, where you can borrow money up to a certain pre-approved limit, and each time you make a payment, as long as your account remains in good standing, you’ll have the credit available to you again.
For example, if you spend $20,000 of your $40,000 line of credit, you have $20,000 of available credit remaining. If you then make a $10,000 payment, your available credit goes back up to $30,000 (minus interest each time, of course). That means you have $30,000 available to spend on home repairs, new furniture, or even to pay off high interest credit card debt. Like credit cards, a home equity line of credit can tempt you to spend money you don’t actually have.
Revolving Credit Can Lead to Serious Debt Problems
Serious debt problems and financial trouble can result from living a credit-dependent lifestyle. With revolving credit, there are no fixed monthly payments and only a minimum payment is required. Without a fixed payment, it’s easy to lose track of what you owe or wait too long to pay off the debt.
The problem can be much worse if the line of credit only requires interest payments. If you get into the habit of only repaying the interest, you could put yourself into more debt than you realize. No matter how low line of credit interest rates are, you don’t want to keep paying them forever.
Decide If Your Purchase Is a Need or Want Before You Pay for Something With a Home Equity Line of Credit
Before using your home equity line of credit to make a purchase, ask yourself if you can make the same purchase with cash. If it’s something you can easily pay for with the money in your chequing account, it’s best to do that. A HELOC is not meant to pay for everyday expenses.
If it’s a big-ticket expense that you need credit to buy, figure out if you really need to make the purchase and how quickly you can pay it off, keeping in mind that interest rates can change.
If it’ll take you years to pay off that purchase, give yourself a few days to mull it over. You may find that after a few days and a careful look at your household budget, you’ll realize that you don’t really need or even want it anymore.
How to Deal With Debt From Revolving Credit Lines or Low Interest Loans
There are a few ways to avoid getting into trouble with revolving credit and living a credit-dependent lifestyle:
- Talk to your lender about setting up automatic monthly payments that cover the interest and part of the principal, so that you’ll have your line of credit paid down over a specified period of time.
- Set up automatic payments that cover more than just the interest with internet or online banking services yourself.
- Create and actively use a realistic household budget that accounts for all of your weekly, monthly and irregular/seasonal expenses. It’s often these “seasonal” expenses that get paid for with a line of credit.
- Ask for help if you need it. If you’re in debt and struggling to get ahead, contact us by phone, anonymous online chat or email and one of our credit & debt counsellors will be happy to review your situation with you.
Understand How Variable Interest Rates Affect You
The HELOC interest rate is the lowest rate available on revolving forms of credit. The rates are based on the Prime rate plus a small percentage, whereas some credit cards have rates as high as 29% or more. When a credit product comes with a variable interest rate, this means the amount of interest you pay will change – for better or worse.
Before signing up for a home equity loan or line of credit, estimate whether your budget can afford to make payments that are at least double to what you’re being charged today. Even if your payments never go up, it’s wise to be prepared in case they do.
A Home Equity Line of Credit (HELOC) or Loan Shouldn’t Be Your Personal ATM
If You’re Feeling Overwhelmed by Debt, We’re Here to Help
A home equity line of credit (HELOC) or a home equity loan can be valuable tools to help you deal with debt and all that life throws your way. However, just like any tool, they need to be used as they were intended. If you’re already in debt and need help figuring out what to do, we’re here to help. Call us toll-free at 1-888-527-8999, send us an email, or chat anonymously to get started. One of our credit counsellors would be happy to answer your questions and help you find solutions in a free and confidential appointment. We’ll do what we can to help you keep your home safe.