I have helped clients set up mortgages and home equity lines of credit (HELOC). Many client's are not completely aware of how a home equity line of credit and what are the advantages and disadvantages.
I wanted to clear that up in this article. Let's look at the advantages (pros) and the disadvantages (cons) then delve into them more deeply.
The Pros of a Home Equity Line of Credit
- Interest only payments
- Best variable rate available
- Some lenders offer a fixed interest rate option
- Get access to equity in your home and pay interest only for what you are using
- Flexibility to use the money when you want and for what you want
- Use the money then pay off the balance without penalty
- Low or no set up costs (could be both an advantage and disadvantage)
The Cons of a Home Equity Line of Credit
- Unpredictable payments
- Your home is at risk
- Lender could change the limit
- You may never pay it off
- You may buy things sooner than you need
- Cost to set up
Let's review these advantage and disadvantages of a Home Equity Line of Credit in more detail
Advantages (Pros) of a Home Equity Line of Credit
Interest Only Payments: The HELOC is traditionally set up with an interest only payment. That is, you pay interest on the balance that is outstanding.
Having an interest only payment can help with your cash flow. You aren't required to pay off the principle balance unless you want to.
Best Variable Rate Available: The Home Equity Line of Credit is traditionally offered with an adjustable interest rate. Some lenders call it a variable interest rate. The interest rate is based on the lenders prime lending rate.
The prime lending rate is defined as a lenders best (lowest) lending rate available to customer. In Canada, lenders will offer rates from 0.50% above prime to 1.50% above prime.
When are going through the process, it's important to ask what interest rate you are being offered and how that rate related to the lenders prime rate.
A home equity line of credit rate will be lower than an unsecured line of credit. For an unsecured line of credit, the interest rates are usually 3.0% or more above prime.
Some Lenders Offer A Fixed Interest Rate Option: If you have a home equity line of credit and you aren't using the account to the fullest advantage, the lender may offer a fixed interest rate option.
This fixed interest rate option will convert a portion of your home equity line of credit from an open variable flexible product to a mortgage with a fixed term, amortization, principle and interest payment.
Sometimes the mortgage rates are lower than the prime lending rate and sometimes they are not.
Check with your mortgage broker or specialist to see what might be best for your situation.
I've worked with many clients to review their home equity lines of credit. We have found solutions and strategies using the fixed interest rate option that have saved them thousands of dollars every year.
Get Access To The Equity In Your Home And Pay Interest Only On What You Use: Home values are very high in many areas of Canada. If we have paid off our home, even if we have only paid off half of our homes, we have build substantial equity.
A home equity line of credit is a great tool that can allow you access to some of the equity in your home an preferential interest rates. You can just set it up and use the line for an emergency or for a major purchase.
I have had many clients who were planning to retire within the next few years. We helped them set up a home equity line of credit so that they had something for the future. When they retire, they may not qualify for the same amount.
By setting up the HELOC while still working, they were able to get things in place and not worry about it once they are retired.
Flexibility To Use The Money When You Want And For What You Want: One of the comments that I hear from clients 3 and 6 months after they set up a home equity line of credit is that they appreciate having it in place.
They can just write a cheque for something when they need to . They don't have to go through all the questions and qualifying, after it's set up, every time they need money.
Whether you are buying a car or making renovations to your home or investing in something. Once the home equity line of credit is set up, you can just write a cheque!
Use The Money Then Pay Off The Balance Without Penalty: The HELOC also offers convenience and cost savings. If you buy something, then sell it after. You can just pay off the money you used on your home equity line of credit.
There is no penalty when you pay down or pay off your HELOC. You can draw the money then next day after you pay if off if you want. You can use it and pay if off every day if you wish.
This is much more convenient than a personal loan or a mortgage, where there are penalties to pay off more than the pre-payment privilege allowed.
Low or No Set Up Costs: Any time you set up a loan or mortgage or HELOC that uses your home as collateral, then there will be some costs. The bank will want to know what your home is worth. Based on the value, they can then provide you with a maximum HELOC that you can qualify for.
The bank will also register an interest in your home. That is, they register a mortgage document for the amount of HELOC that you are approved for. If you fail to make payments or sell your home, then this registered document is their protection to get paid from the sale proceeds.
To register their interest in your home, the lender will use a solicitor or notary. The fees for the solicitor or notary will be charged to you.
The costs to set up a HELOC vary from province to province, but you could budget $2,000 to $2,500 . I'll review some of the costs in more detail below.
Disadvantages (Cons) of a Home Equity Line of Credit
Unpredictable payments: Because your HELOC is set up with an adjustable (variable) interest rate, if rates go up and down, then you minimum payment required will go up and down.
The payment is also based on the balance outstanding. Therefore, if you draw down a substantial amount so that you owe much more than you did the previous month, then your payment will go up a lot.
It's important to be aware and budget for the fluctuations that you might see with a HELOC.
Not all of my clients are aware of this and that's why I have placed the unpredictable payments in the "con" section.
Your Home Is A Risk: The home equity line of credit is set up and your lender will register an interest in your home. That means that if you don't make the payments, the lender could foreclose.
The HELOC is registered with what is called a collateral mortgage document. If you sell your home, this collateral mortgage document must be discharged by your solicitor or notary and the balance of your HELOC must be paid in full.
If you fall behind in payments, the lender could force the sale of your home so that they can recover the money that you owe them. That is, the lender goes through a foreclosure process.
Lender Could Change the Limit: When the HELOC is set up, an appraisal is done to determine the value of your home and the limit that the lender will allow.
If the market changes substantially, the lender could complete another appraisal and lower your limit. If your balance is close to the original limit, then the lender could demand payment to bring the balance down to the new limit.
This doesn't happen often, but it can happen and must be considered a risk to you and certainly a disadvantage of the HELOC.
You May Never Pay If Off: Because the HELOC is set up with interest only payments, you could potentially keep the balance the same and never pay it off.
When I work with clients who have home equity lines of credit, I often discuss and review how and why they are setting up the HELOC. This shouldn't be a never, never plan.
In my opinion, everyone should be choosing products and financing that will get them into a better financial situation. The HELOC is a fantastic product with a great deal of flexibility.
The flexibility can get clients into trouble because they get used to making interest only payments and never pay off the principle.
There are some easy things that you can do to make sure you don't get into that situation:
- You could convert some of the open variable balance to a fixed principle reducing balance. This will increase the payments, but you will now be paying down the balance.
- You can set up an automatic payment to your HELOC that is greater than the interest payment. That way you are always paying down the principle.
You May Buy Things Sooner Than You Need: Sometimes I meet clients who see all that available money and just can't help themselves.
For example, A had been planning to purchase a new RV in a few years. The HELOC limit is too enticing and they end up buying the RV a few weeks after the home equity line of credit was set up.
These clients saw all the money they had access to and couldn't help themselves. The did sell their previous RV and paid down the HELOC, but they could have waited for a couple more years.
I only knew about this story because I had connected with them a few months after setting up the HELOC. We talked about how things were going and they told me that I should warn my future clients.
The said that people shouldn't think about this a money. That people should think about the HELOC as debt. The said that they made a commitment to each other how much and for what reason they should go into debt.
This commitment to each other helped them for future purchases, or lack of purchases.
Set Up Costs: Compared to an unsecured line of credit which is free, the set up cost for a Home Equity Line of Credit is quite a bit. Each province has a different fee structure to register a mortgage through the respective land titles offices.
There is also an appraisal fee to determine the value of your home. A lender wants to know how much your home is worth because they are approving something for you that does not have to be paid off.
A HELOC is considered a higher risk product for a lender. Home values typically go up but sometimes they go down. They want to be certain of the value of your home, but ordering an appraisal, before they set everything up.
I think that the costs are both a pro and a con. There are some ways to get the costs down and let's talk about that next.
What are the closing costs for a Home Equity Line of Credit?
The set up costs for a Home Equity Line of Credit can vary from lender to lender. The costs will include an appraisal fee to determine the value of your home and legal fees to register a lender's interest in your property. Lenders may offer incentives at different times of the year to cover some or all of these costs.
Lenders have different seasons where they will be more or less aggressive with client acquisition. If they want more market share for one reason or another, they could offer to pay for set up costs or they could offer a lower initial interest rate. That always depends on the lender.
If you work with a mortgage broker, then you can find out which lender may be offering a deal to set up a Home Equity Line of Credit.
HELOC's are set up slightly different with each lender. Some are better than others. Some have lower interest rates than others. Some have lower set up costs than other. It's hard to know all the nuances that each lender offers just based on the material they publish to the public.
If you want someone on your side, connect with us, we can help you understand what might be better for your specific situation.