What is a Home Equity Line of Credit?
Need to take out a loan but interest rates have you thinking twice or even three times about doing so? If you’re a homeowner, you can take out a line of credit using your home as collateral instead. A Home Equity Line of Credit (HELOC) serves as a pre-approved pool of cash you can dip into whenever you want. But unlike other lines of credit, like a credit card or unsecured personal line of credit, your interest rate is usually very low. You can have a stand-alone HELOC or one that is combined with a mortgage, which gives you the benefit of increasing your HELOC borrowing room whenever you pay down your mortgage. Unlike a mortgage or home loan, a HELOC has a variable interest rate; in Canada, it’s often linked to a Prime Rate that usually follows changes in the Bank of Canada benchmark interest rate.
How much equity do you need for a HELOC?
To qualify for a HELOC, you need to have enough equity in your home. Your equity is the value of your home minus any mortgage balance outstanding. In Canada, the maximum credit for the HELOC is 65% of your home’s value; in the US, you can establish a HELOC for up to 80% of the home’s value. But this percentage also includes how much you still owe on your mortgage.
For example, let’s say your home’s market value is $600,000 and you still owe $350,000 on the mortgage. The theoretical maximum HELOC limit you could get in Canada would be 65% of 600,000, or $390,000. Taking into account your mortgage balance of $350,000, you could qualify for a $40,000 HELOC.
In the US, the maximum HELOC limit would be 80% of $600,000, or $480,000. Subtracting your mortgage balance of $350,000 gives a maximum HELOC credit limit of $130,000.
The closer you are to paying off your mortgage (the less money you owe on it), the larger the HELOC you could qualify for.
To estimate the value of your home, look at listings for homes in your neighbourhood. In Canada, you can use an online property value estimator. In the US, you can use Zestimate by Zillow. Then use a HELOC online calculator to see how much you could qualify for and how you could take advantage of the HELOC to make investments, pay off other loans, and save money.
Is getting a HELOC a good idea?
The answer is that it depends. If you’ve decided to borrow money using your home as collateral, aside from a HELOC you could refinance and borrow from your mortgage or to take out a second mortgage.
If you’re considering getting a second mortgage, be aware that these mortgages often have a higher interest rate than first mortgages or even HELOCs. You should carefully examine your budget to see if you can make the regular payments required, not to mention the mortgage payments for your first mortgage, for the term length. You won’t have the flexibility of a HELOC in being able to pay down the principal whenever you want to. Consult a mortgage broker about this option.
You could refinance your home, increasing the mortgage amount and withdrawing the extra money to spend however you wish. In Canada, you can usually borrow up to 80% of the value of your home. If you have less than 80% of the home’s market value left on your mortgage, refinancing is an option you should consider. In contrast, the maximum limit for a HELOC is 65% of your home’s value, so you would need to have equity of 35% or more in your home.
Let’s use our previous example where your home’s value is $600,000 and your mortgage balance is $350,000. The 80% amount you can borrow against the home is $480,000. So you have up to $130,000 ($480,000 – $350,000) that you can request if you refinance your home by getting the mortgage for that amount. Remember that if we used a HELOC instead, the maximum HELOC limit would be $40,000 ($390,000-$350,000).
Keep in mind that a HELOC is a revolving line of credit that is always open for use, and you’re not forced to borrow from it at any time. In addition, you can choose to make interest-only payments until you’re ready to pay down the principal. With refinancing your mortgage or a second mortgage, you’re locked into regularly scheduled payments.
When should I use a HELOC?
You should use a HELOC with care and for specific one-off purchases. Although a HELOC is a line of credit, you shouldn’t use it to supplement your income for the lifestyle you wish. Taking equity out of your home (borrowing money against it) is a serious decision. If you choose a HELOC with your home as collateral and don’t make the required payments, your home is on the line.
Having a HELOC can be a Plan B if a time comes when you need lots of money fast like in an emergency or during a period of unemployment. The HELOC can stay open and unused without costing you anything until you begin to draw from it.
A HELOC is also great for smaller loans that you can pay off quickly. A vacation, new furniture, and tuition are good examples of such purchases as you can usually pay them back over a year or two. Using a HELOC versus a credit card or payday loan gives you the advantage of not having to pay high interest rates, saving you lots of money in interest. The best use of a HELOC is for making improvements or renovations to your home. You could increase your home’s value by far more than the interest you would have to pay for using the HELOC.
HELOCs have a variable interest rate which is usually a little higher than the first mortgage interest rate. If you have long-term expenses such as medical bills that will take quite a while to pay off, refinancing may be a better option. In addition, you could consolidate your higher-interest loans, such as a car loan and credit card debts, and pay them off with the proceeds of refinancing your mortgage. As the mortgage is at a lower interest rate (and often much longer amortization) than the high-interest loans, you’ll have less of a burden on your budget and be able to benefit from savings on interest.
How does a HELOC affect my credit score?
Even though it’s backed by your home as collateral, the HELOC is still a revolving line of credit. It appears on your credit score along with similar loans such as credit cards. A HELOC usually has a positive effect on your credit score with only a few exceptions.
When you apply for a HELOC, potential lenders will have to make a hard credit inquiry. This can have a small temporary impact on your credit score. When you open a HELOC, you can get benefit from a decreased credit utilization rate since your total borrowing compared to your total credit limit is decreased. There’s no impact on your credit score if you use the HELOC infrequently, and regular on-time payments to your HELOC can boost your credit score. But if you take out a large amount from your HELOC, that could increase your credit utilization and decrease your credit score. If you close your HELOC, you will lose the benefits of its credit history and low utilization rate in your credit score calculation. This may only be an issue if you don’t have a credit card or have a short credit history.
Which one is better for financing – a HELOC or refinance?
We’ve backed up our “it depends” answer with information on both the HELOC and refinancing. For smaller specific purchases or home remodelling, a HELOC is the best choice. For larger purchases that you’ll need time to pay off, refinancing your home is the way to go. Either is preferable to putting a significant purchase on your credit card unless you can pay it off in full immediately.
The HELOC has a more flexible payment option than increasing your mortgage. As long as you regularly pay off the interest in a HELOC, you can choose when to pay back the principal you borrowed. When you increase your mortgage to refinance your home, the extra interest and principal are folded into your regular payments for the entire length of the mortgage.
However, we strongly advise that you use neither a HELOC nor refinancing your mortgage to supplement your income to live the life of your dreams.