The radio ads for home-equity loans make it all sound so easy. The basic message is this: if you own your own home, you can get a loan, pronto, no matter how crappy your credit rating and even if the banks have turned you down before.
Plus, the advertisements make them sound so tempting: maybe you want to renovate your 1970s kitchen, buy a cottage or jet off to a tropical paradise.
Although home equity loans might have some obvious appeal, there are pros and cons to signing on the dotted line.
“People may want to go on vacation because they’re sick of winter and know they can get another $10,000 out of their house and think ‘Why not? I’m not going to be declined.’ But people should be wary of that,” says Jeffrey Schwartz, executive director of Consolidated Credit Counselling Services of Canada.
“The risk is that if you default on the loan, the lender can sell your house to get their money back. If they ever need to collect, they put your home on the market.”
There are two types of home equity loans: a fixed-term loan and a line of credit (HELOC). A home equity loan provides a one-time lump sum that gets paid back monthly with a fixed interest rate within a specific time frame, usually 10 to 15 years. No wonder it’s also known as a second mortgage. A HELOC, meanwhile, provides access to funds when you need them and that you pay back like a credit card, with a minimum down payment. It has an adjustable interest rate, usually tied to the prime lending rate.
Both let homeowners borrow money by leveraging the equity in their homes — in other words, by using the equity in their home as collateral.
While the interest rate on a home equity loan is typically higher than that of a first mortgage, it’s usually much lower than credit cards. In fact, paying off credit card balances and other outstanding debt is a common reason people turn to these types of loans. Plus, interest paid is tax deductible. (Corrects to show interest paid is not tax deductible unless the loan is used to earn income through a business or investment).
How does it work?
Home equity loans are based on the increased market value of your home. Here’s the formula to figure that out:
Value of Your Home – the Amount Owing on Your Mortgage = Home Equity.
So say you bought your home 20 years ago for $200,000 and have paid $150,000 toward your first mortgage. The amount owing is $50,000. Meanwhile, in the last two decades, the value of your property has gone up, and it’s now worth $750,000. So $750,000 minus $50,000 equals home equity of $700,000.
Sounds great, but there is a cap on how much homeowners are allowed to borrow.
People used to be able to borrow up to 80 per cent of the value of their home on HELOCs, but the federal government recently took steps to limit the amount Canadians can borrow against their home equity this way. The latest Superintendent of Financial Institutions guidelines indicate financial institutions must maximize the loan-to value ratio of 65 per cent or less. Additional mortgage credit beyond that LTV ratio limit of 65 per cent can still be extended to a borrower, but the portion over 65 per cent is to be amortized.”
The downside of home-equity loans
Home equity loans are based on market value and things can go seriously awry if the market tanks and the value of your home decreases. You could end up owing on your home equity loan even after selling your home.
“If the market changes, it affects how much equity you have your house,” Schwartz says.
And if you can’t make the required payments on your home equity loan, your home is at risk of foreclosure. In other words, you could lose your home.
Schwartz notes that it’s worth doing a thorough financial review before taking on more debt. However, he notes that for the most part, Canadians don’t mess with their equity.
“The neat thing about Canadians is we pay for our homes first,” he says. “It’s a rarity when we get behind on mortgage payments; delinquency rates are low. People pay for their shelter and they don’t want to risk that. Typically for the banks, it’s [home-equity loans are] a safe business to go into.”