What Is a Home Equity Line of Credit (HELOC) and How Does It Work?

What is a Home Equity Line Of Credit (HELOC)?

A Home Equity Line of Credit (HELOC) is a revolving credit secured against your home. This helps you borrow, repay, and borrow again up to your approved credit limit.

• Revolving credit: A flexible loan in which you can access funds as needed, pay them back, and reuse them.
• Credit limit: Your lender determines your credit limit based on your home’s equity and financial profile.
• You only pay interest on the amount you borrow, and your lender may require:
• • Interest-only payments, or
  • Payments that cover both

Usually, mortgages have a fixed amortization period, but in Canada,  HELOC doesn’t have a predetermined repayment term. Lenders could have particular requirements for repayment, though, like switching to principal and interest after a predetermined time.

When to consider

Lenders permit you to borrow (mortgage plus HELOC) of up to 80% of your home’s value. 

Therefore, if your mortgage is $200,000 and your home is worth $500,000, your HELOC may reach $200,000. You can access that money at any time.

You can use your home equity line of credit for various purposes such as:

• Home renovations
• Buying a car
• Medical expenses
• Education Expenses
• Investment opportunities
• Debt consolidation
• Residential property

A HELOC comparison to a home equity loan

Both HELOC and home equity loans let you use your equity.

Home equity loan 

• Gives you a lump sum of money. 
• Have fixed monthly payments. 
• Have fixed interest rates that ensure predictable payments.

HELOC 

• provides easy ongoing access to funds 
• Has interest-only payments.
• Have variable interest rates. 

Once your application is approved for a line of credit, you can use funds as needed and repay the amount with interest, the only amount you have used.

Eligibility for home equity credit lines

You can be eligible to apply for a HELOC if you have at least 35% equity in your home. Using your house as collateral could give you a higher credit limit and a lower interest rate.

Is HELOC a good idea?

In Canada, more than 35% of homeowners own a HELOC, indicating how common these loans are there. 

This is not always the best choice for everyone, because it has advantages and disadvantages. 

Advantages of HELOC

• Provides flexibility: HELOC lets you borrow funds as needed. You can make use of them if an opportunity or any financial need comes up. It can be used to finance home renovations that raise the value of your house, or even consolidate debt to reduce interest rates. 

• Competitive interest rates: HELOC interest rates are generally lower than credit cards and personal loans.

• Make interest-only payments:  Minimum payments you pay are based only on interest.

• Easily make additional payments: Making prepayments has no consequences. 

• As this is not a lump-sum loan. You can borrow any amount, up to your limit at any time.

What are the risks involved with the HELOC?

HELOCs have benefits, but they also come with risks.

Some of them are:

• If the interest rates increase, this would be difficult to pay back, especially if you take out a lot of money.
• If you get default on your HELOC, you could lose your home
• It reduces the equity in your home, which may:

• Impacts your financial security 
• Restricts possibilities for the future if you are considering selling your house.

• You will not be able to repay your debt if you just pay interest.
• Easy access to money could lead you to take on more debt than you can manage.
• Because the interest rate is variable, the amount of your repayments may increase.

Reduce the risks

There are a few ways to reduce the risks:

• Set up regular automatic payments to ensure that interest is paid on schedule.
• To keep spending under control, do not link to a debit card.
• Online banking makes it simple to keep track of your balance.
• Get loan insurance to protect your ability to repay.

Exploring Home Equity Lines of Credit(HELOC)

HELOCs come in two types:

• HELOCs combined with a mortgage
• standalone HELOCs

You can borrow against your home equity using other programs as well. Reverse mortgages and home equity loans are two examples of these programs. They are not the same as HELOCs.

HELOC combined with a mortgage

Your mortgage determines the HELOC. That means you have to sign it with the same lender that gave you your mortgage. 

As you pay off your mortgage, your available credit increases. Some may refer as a readvanceable mortgage.

Under their own brand names, a number of financial institutions provide a HELOC combined with a mortgage.

Standalone HELOC

There is no connection between your mortgage and HELOC. Your credit won’t increase if you pay off your mortgage. You should choose different lenders for your mortgage and HELOC. If you don’t have a mortgage, you can get this standalone HELOC.

The majority of large banks provide HELOCs on their own. It can be used to purchase a home instead of a mortgage. Think carefully about the pros and cons before applying.

For example:

• You can repay the principal amount at any time
• You may pay off the loan without prepayment penalties
• You can have more equity by paying a higher down payment
• Interest rates are higher

How does HELOC work?

HELOC is a revolving credit line that lets you borrow against the equity in your home. Your house is used as collateral. It works just like a credit card, allowing you to borrow, repay, and borrow again up to your credit limit.

Draw Period & Repayment Details

• You can borrow as much as you need up to your credit limit, during the draw term, which is usually ten years,
• Next comes the repayment period, which usually lasts 20 years, during which you have to start repaying the loan.

Payments: The HELOC process in Canada makes funds easily accessible through a revolving line of credit. To pay off your loan you have to make monthly interest payments plus the principal amount. 

How Does a HELOC Work in Canada?

In Canada, you apply via a financial institution or bank. Your house's equity determines whether you qualify for a HELOC. As you pay off your mortgage or the value of your house increases over time, your equity may increase.

In Canada, if you borrow from a bank or other federally regulated financial institution, your HELOC can be no more than 65% of the home's appraised worth. Your home equity line of credit limit may also be up to 80% of the value of your house if your lender combines it with the existing mortgage. As the prime rate fluctuates, the interest rate fluctuates as well.

HELOC Interest Rates & Fees:

The interest rate on HELOCs is usually variable, it fluctuates with the prime rate. There may be additional administrative costs associated with HELOC, including:

• Appraisal fees
• Title search and title insurance fees
• Legal fees

Requirements

• When you apply for a HELOC, lenders usually ask you to look at your financial details, and if you are eligible.
• Your house's equity will determine your credit line amount and eligibility for a home equity loan (HELOC).
• Other factors include: your debt-to-income ratio and the lender must be assured that you’re able to pay off your loan.

• It is difficult for retirees to qualify for HELOC because it requires a good credit score. 

Calculating the amount you may borrow 

You can borrow up to 65% of your home’s value with a HELOC.

The maximum HELOC you borrow may depend on:

• Your home’s value
• Your home equity
• Your credit limit

Home’s value:

Lenders determine your home’s value by using: 

• professional appraisal or 
• purchase price of your house 

They use this amount with equity to estimate the loan-to-value ratio.

Home equity:

Your home equity = home’s value - outstanding mortgage(any debt you have on your home)

An example:

• Your home’s value: $500,000
• Your outstanding mortgage $200,000
• You have $300,000 ($500,000 - $200,000) in equity, which equals 60% of your home’s value.

Credit limit:

You can negotiate with your lender to lower the credit limit on your HELOC. You can be approved for a bigger amount than you actually require by lenders. This could lead to overspending. You can request your lender for a reduced credit limit will help you avoid overspending and stay within a budget. 

How to Access Funds or Pay Off Your Mortgage with a Home Equity Loan

With a Home Equity Line of Credit (HELOC), you can access funds as needed instead of receiving them all at once. As long as you make the minimal monthly interest only, you can borrow as much as you need. Paying just the interest, and leaves the principal unpaid, which eventually costs you more. It's better to have a repayment plan in place and pay more than the minimum to avoid long-term debt.

HELOC can be utilized to pay off your mortgage. This gives you flexibility because HELOC payments might be lower, but you might end up paying more in interest than you would with a conventional mortgage. Also, if the prime rate increases, your payments may go up because HELOCs have variable interest rates.

Another flexible option is a reverse mortgage, which lets you access the equity in your house without having to make any monthly payments. Rather, the loan is paid back when you sell or move. For retirees who want to free up money without worrying about income-based eligibility, this can be a smart choice.

Make sure you understand the conditions, interest rates, and payback requirements before taking out a loan, whether you're using it for spending or to pay off your mortgage.

HELOC Vs Reverse Mortgage

Your financial needs determine whether you should use a HELOC or a reverse mortgage.

Flexibility, reduced interest rates, and access to up to 65% of your home's value are all provided by a HELOC; however, in order to be eligible, you must have good credit and make monthly interest payments. A reverse mortgage, on the other hand, has somewhat higher interest rates and gradually reduces home equity, but it allows homeowners 55 and older to access up to 55% of their house's worth without making monthly payments.

A HELOC can be the best option if you require flexibility. A reverse mortgage can be a better option if you would rather have no monthly payments and simpler qualifying. 

Disclaimer: This content is based on current facts and intended purely for informational purposes. Always ask your lender about current details.