No one wants to retire in debt. But if you are one of the growing…
If you are overwhelmed with credit card debt, you may have considered a home equity line of credit (HELOC). Financial experts view home equity as an untapped resource. As a homeowner, when you have more bills than you can handle, there are several options, including HELOC, available to you. But, before you take action, you’ll want to have all the facts.
What is a HELOC?
Home equity, of course, is the difference between the value of your home and what you owe. A HELOC allows you to borrow that money with a promise to repay it in the future. If you have equity in your house, you can use it. It may not be the best idea, however, if you are trying to eliminate unsecured debt or meet your monthly living expenses. For one thing, a HELOC is secured by your home.
Yes, a HELOC does give you access to the money you have vested in your house. For many Canadian homeowners, that value is currently going up. A HELOC unlocks the value, which can then be used for a variety of purposes. Some of the more common ways that people use home equity loans and lines of credit include home improvements, education, health care expenses, and debt consolidation.
A HELOC provides a flexible line of credit. You take what you need up to the approved amount only when you need it. You can use this money to pay off unsecured debt if you choose. That would be an okay strategy if you paid off all debt and avoided making any more. But is it the best way to handle out-of-control bills?
How Does a HELOC Work?
Once you’re approved for the line of credit, you can access the money through a debit card or cheques. Although a HELOC is easy to use, borrowers need to pay close attention to the terms, as they vary widely. Some HELOCs, for example, let you access the line as often as you like over an extended period of time. During this active period, you can make interest-only payments. Others have much shorter time frames for when you must begin to repay the principal.
Once the principal repayment period starts and the line is no longer active, the terms specify how long you have to repay the loan. However, you can keep the line open and avoid repaying the entire principal amount by reapplying after the time indicated in your credit agreement has passed.
Canadians currently have over $260 billion in HELOCs. The real growth rate, however, is declining. This wasn’t the case in 2016 and 2017 when Canadian home prices were accelerating at a similar pace. It could be because homeowners aren’t feeling bullish about the post-pandemic economy. It could also be a sign that the optimism about increasing housing prices is slipping.
How much can you borrow?
In Canada, you can borrow up to 80 percent of the home value minus the remaining mortgage balance. Consider a $400,000 home. Eighty percent of the home value is $320,000. With an outstanding mortgage balance of $280,000, there is $40,000 remaining. That is the maximum amount you can borrow with a HELOC, if you qualify.
How do you qualify?
To qualify for a HELOC, most lenders require that you have 20 percent or more equity in your home. In addition, you’ll need a good credit score. If you’ve been missing or skipping credit card payments, that could be your biggest obstacle.
Lenders also need proof of sufficient income and an acceptable debt level. They perform what is known as a stress test to see whether you can afford to make the payments. This test uses a higher rate than your actual contract. The rate is based on either the higher of the Bank of Canada conventional 5-year mortgage rate, or your negotiated interest plus two percent. Recent changes to stress test rules make it increasingly difficult to qualify. The ultimate contract rate will fluctuate with prime.
Why HELOCs are attractive?
For the lender, a HELOC is secured by a house. This means it’s not as risky as an unsecured loan so the interest rate is typically lower. It is revolving credit just like your Visa or MasterCard. As mentioned, you borrow what you need up to a predetermined amount. But here is where the similarity with your unsecured credit card ends: If you default on the loan, the lender can take your home.
How to Apply for a HELOC
In addition to an acceptable credit score, you’ll need to present documents including pay stubs, tax receipts, bank statements, and credit card statements. You’ll also need mortgage details, such as the current balance, term, and amortization period.
What are the fees?
While the interest rates on HELOCs are lower than other types of consumer loans, the fees can be extensive. They may include:
- An administrative fee between $150 and $200
- Loan origination fee up to 1 percent
- Legal or notary fees to register your home as collateral $500 to $1500
- Appraisal fees up to $500
- Discharge or cancellation fee of roughly $200 to $350
- Closing costs up to $350 or more
- Transaction, Withdrawal or Balance fees which vary by lender
What Should You Consider Before Taking Out a HELOC
A HELOC can be used to increase the value of your home. If you repay it quickly, it’s not such a bad idea. Of course, there are many ways that you could use a home equity line of credit that wouldn’t be necessarily bad. As a secured loan, the interest rate is lower than many other options and there really are no restrictions on how you use the money. But here are several examples of when you should think twice about a HELOC:
- Your financial future looks uncertain.
- Your job situation is tenuous.
- Your budget is tight and you have a monthly cash flow issue.
- You have a burdensome amount of unsecured debt.
- You may need to relocate in the near future.
The housing market in your area is destabilized or likely to be.
In these cases, the negatives far outweigh the positives. Even if you shift the debt around, debt is still debt. There are better options. Following are some of the cons to keep in mind.
What are the cons?
The fact that you can lose your house is probably enough of a reason to think twice about a HELOC. But there are other reasons to think hard before you sign on the bottom line. For example:
Payments can increase or terms can change.
The interest rate is likely to fluctuate which can increase your payments and the amount that you pay overall. The lender can lower your credit limit or change your payment terms and you have no recourse. If you appear to be struggling financially, the lender can demand payment.
Housing prices may decline.
Although prices are currently inflated, the state of the post-pandemic economy may not support housing values. If the value of your house declines below the value of the loan, the loan is no longer secured. In this case, the bank could call in the loan.
This may not seem possible in the current housing market. However, when housing prices rise too rapidly, market instability may follow. This is called a real estate bubble. Real estate bubbles occur when, among other reasons, market prices begin to exceed demand. When the bubble bursts, prices can decline sharply.
A HELOC changes your financial standing.
Your secured debt load is increased and your credit score will immediately drop (although it may be temporary). Further, you can make the minimum payment for years and never reduce the principal. As mentioned, some HELOCs allow you to make interest-only payments for a period of time. If your financial circumstances change during this time period, you will have difficulty repaying the loan.
Finally, is a HELOC a good way to avoid Bankruptcy? Possibly so. But it’s important to understand that Bankruptcy is not the only option.
Dealing With Your Debt by Filing Bankruptcy or a Consumer Proposal
You may have considered and reconsidered Bankruptcy. Bankruptcy gives debtors the opportunity to wipe the slate clean so that they can start down the path toward a better financial future. While it may seem like a last resort option, it is a viable one in certain situations. However, if you have significant equity in your home, you may want to consider a Consumer Proposal.
A Consumer Proposal allows you to eliminate a large portion of your unsecured debt. And with your unsecured debt under control, it will be much easier to manage your finances. A Consumer Proposal is a legal procedure. You’ll work with a Licensed Insolvency Trustee to nail down the terms of the proposal, paying back a portion of what you owe. They are the only people licensed in Canada to file a Consumer Proposal or Bankruptcy, if that is the better option, on your behalf.
The best thing about these options is that neither of them involves taking on debt that is secured by the very asset you are trying to protect: your home.
How a Licensed Insolvency Trustee Can Help
It makes sense to get all the information you need to make a smart financial decision. Whether or not you are still considering a HELOC as a possible way out of debt, talk to an Adamson & Associates Inc. Licensed Insolvency Trustee first. Our professionals can provide you with all choices. There are better solutions than shifting the money you owe from point A to point B.
We can help you drastically reduce or eliminate your credit card debt so you can see your way clear to a better financial future. Call Adamson & Associates Inc. today at 519-310-JOHN (3546) for a free, no-obligation consultation.