After buying a house in 1986, my husband and I became mortgage-free in 20 years. We made accelerated twice-monthly payments and added lump-sum cash amounts when we could. In other words, we paid more than the minimum demanded by the bank, allowing us to save a great deal of interest.
But paradoxically, while working hard to burn the mortgage, we still borrowed against our property using a $100,000 home equity line of credit (HELOC) advanced by the bank at the purchase and another $25,000 home equity line of credit advanced later (I can’t remember why).
A HELOC is a line of credit secured against the borrower’s home. Canadian homeowners can get access to up to 65% of the value of their home through a HELOC. But the sum of the outstanding mortgage balance and the HELOC must not exceed 80% of the value of the home.
Our HELOCs didn’t require any principal payments, so we often paid only the monthly interest – the minimum that the bank demanded – and no more. The extra money helped support the cost of bringing up two children in Toronto on one full-time income and one variable income. The HELOCs are still registered against the house to be used only in case of disaster, but today we're HELOC-free. We now have savings to pay for most discretionary spending without running up our credit balances. But I remember the delicious – and guilty – thrill of being able to get access to money for anything we liked within minutes. No need to sit down with a bank manager and sign a bunch of documents.
Borrowing against home equity can be ridiculously easy with HELOCs. They are now the single largest contributor to non-mortgage household debt, far surpassing credit cards, and expanding because of low interest rates (many clients get the banks’ prime lending rate of 3.95%) and rising house prices. Financial institutions have also boosted HELOC sales with innovative products, favourable lending terms and major investments in marketing.
However, some federal government sources are concerned that home equity extraction could hurt the economy in a future downturn and damage consumers’ financial wellbeing.
The risks and overuse of HELOCs
“As home values rise, homeowners find it easier to borrow using their home value as security. This increased borrowing is then used, in part, to finance household spending,” the Bank of Canada said in a 2019 report. Could this leave the economy more vulnerable to a large decline in house prices? Could it exacerbate spending cuts by consumers in bad times? The central bank asked lenders last year to provide more details on HELOCs so it could assess how risky they are to the financial system.
The Financial Consumer Agency of Canada is also concerned about HELOCs. Its research shows many users don’t understand the key terms, conditions, fees and risks of the product they embrace so enthusiastically. HELOCS are “an ongoing area of interest for the Agency,” FCAC spokesperson Lynne Santerre told me. “When used responsibly, they can provide many benefits to consumers, such as low interest rates, convenient access to funds and flexible repayment terms. But there are risks associated with the use of HELOCs.”
I remember the delicious – and guilty – thrill of being able to get access to money for anything we liked within minutes
The federal watchdog hopes to raise awareness about how over-indebtedness makes consumers vulnerable to even small interest-rate hikes. Before borrowing against home equity, homeowners should look at their current debt levels and their ability to repay the debt.
“Don’t use your house like an ATM. Know the risks.” That was FCAC’s message in an ad campaign during last spring’s home buying season that warned consumers of the risks of HELOCs.
Risk #1: The interest rate on HELOCs is variable. As a result, some consumers may have difficulty meeting their debt obligations if interest rates rise.
Risk #2: Consumers can draw on a HELOC without having to reapply for credit. When a HELOC is combined with a mortgage, the amount of available credit increases automatically as the mortgage is paid down. This may encourage borrowing more than consumers can afford.
Risk #3: Since 2018, lenders require HELOC owners who want to apply for additional financing, such as a new mortgage, to prove they can afford to repay their entire HELOC credit limit, not just the balance currently owing. And that’s regardless of whether they’ve used the HELOC or not.
Risk #4: HELOCs allow consumers to make interest-only payments. This is different from conventional mortgages with payments combining both interest and principal, allowing borrowers to pay off their loans more quickly.
It's important to understand the risks of interest-only payments, says the FCAC. For example:
- Before switching their mortgage to another lender, most consumers will have to pay off their HELOC in full, plus any credit products they have with it.
- A lender can reduce a consumer’s credit limit at any time (the lender will provide advance notice of any change).
- The lender has the right to demand that consumers pay the full amount at any time.
“While the overwhelming majority of consumers keep their HELOC in good standing, many are doing so by making the minimum payment (interest-only) or making only occasional efforts to reduce the principal,” the FCAC said in a 2019 research report featuring an online survey of 4,800 Canadians.
More than one in four (27%) HELOC users routinely made interest-only payments, the survey found. Despite making little or no progress on reducing the balance, 62% of these borrowers optimistically expected to repay their HELOC in full within five years. Younger borrowers were more at risk, with 41% of HELOC users aged 25 to 34 saying they paid interest-only most months or every month – compared to 24% of HELOC users aged 65 and over.
Knowing how HELOCs work
When the FCAC asked survey respondents nine questions to assess their knowledge of key product terms and conditions, HELOC users answered less than half of the questions correctly. Some examples:
- “A HELOC’s credit limit can automatically increase when a mortgage or other related products are paid down.” TRUE. (Only 50% knew that.)
- “A financial institution can lower the credit limit on your HELOC at any time.” TRUE. (Only 46% knew that.)
- There are fees to transfer a HELOC to another institution.” TRUE. (Only 45% knew that.)
- “Your lender can require you to repay your HELOC at any time.” TRUE. (Only 39% knew that.)
- “A HELOC is not an installment loan, like a car loan that you pay down over time.” TRUE. (Only 37% knew that.)
- A financial institution can increase a HELOC’s interest rate at its discretion.” TRUE. (Only 15% knew that.)
I asked a mortgage broker and an insolvency trustee about HELOCs and their possible overuse.
“As a pretty busy mortgage broker, I rarely offer a HELOC to my clients,” says Ross Taylor of Ross Taylor and Associates in Toronto. “They are hard to qualify for, since you must have verifiable income. With many applicants barely qualifying for the primary mortgage, a HELOC is not even on their radar.”
The interest rate on HELOCs is variable. As a result, some consumers may have difficulty meeting their debt obligations if interest rates rise
HELOCs bridge the wealth gap between boomers and younger homeowners, allowing children to live the same way as their parents did, says Scott Terrio, manager of consumer insolvency at Hoyes, Michalos & Associates, a licenced insolvency trustee firm based in Kitchener, Ont.
Instead of using a HELOC for renovations to increase their home’s value, which Terrio thinks is the intended use, many people may use the borrowed money for vacations, putting their kids in private schools, boats or luxury pets. He remembers that in the recession of 2008-09, the Bank of Canada cut short-term rates to stimulate the economy. But the major banks raised their HELOC rates – for example, from prime to prime plus 1% – and didn’t lower them until long after the recession ended.
“If the economy turns down again, the banks won’t call every loan, but they will make it more expensive for you,” Terrio says. “They know Canadians see homes as a retirement asset and the last thing they will stop paying is their mortgage or HELOC.”
How to HELOC responsibly
Terrio’s advice? Exercise restraint. Put parameters on the use of your home equity, such as limiting the amount to $5,000 to $10,000 for emergency cash. Tell the bank what you want instead of simply agreeing to a six-figure HELOC.
The FCAC has a guide to getting a home equity line of credit that is worth reading. It explains the two main types of HELOCs: One is combined with a mortgage (sometimes called a readvanceable mortgage) and one is a stand-alone product that can be used as a substitute for a mortgage to buy a home.
In its guide, the FCAC makes the following recommendations:
- Understand your HELOC contract. Read the terms and conditions. Ask your lender about anything you don’t understand.
- Set up a plan for how you’ll use a home equity line of credit. Consider a repayment schedule that includes more than just minimum monthly interest. Make a realistic budget for any projects you may want to do.
- Ask for a lower credit limit with your lender if it suits you better. Lenders may approve you for a higher limit than you need, making it tempting to spend over your budget.
- Recognize the risk of using a HELOC to manage unexpected expenses or emergencies, such as a job loss. If you borrow money to cover your monthly bills for an extended period, you may take on more debt than you’re able to pay back.
When I look back at our HELOC years, I feel we were lucky to have at least one full-time income to cover our basic expenses. We never came close to using all the credit we had. For HELOC users who are heavily in debt, the FCAC recommends its financial goals calculator. And it proposes an interesting idea, one I never knew about when I could have used it.
“Convert a portion of your home equity line of credit into debt with fixed repayment amounts, much like a mortgage loan. That way, you can get into a habit of making regular payments. The interest rate and terms of the debt can be different from that of the home equity line of credit. Ask your lender for more information about this option.”