Home Equity Line of Credit (HELOC)

What is a HELOC or a Home Equity Loan and Can It Help Me Get Out of Debt?

A Home Equity Loan, sometimes referred to as a HELOC, has become an increasingly popular way to access the equity in your residence. In this article, we will explore the difference between a Home Equity Loan and a Home Equity Line of Credit (HELOC). More specifically, we will answer the question, what is a HELOC or a Home Equity Loan and can it help me get out of debt and avoid Bankruptcy?

Secondly, we will explore the pros and cons for each product and point out the need to understand the purpose or need to use either.

Finally, we will point out that the key is having a plan.

What is a HELOC?

HELOC is an acronym which stands for Home Equity Line of Credit (“HELOC”). It is a debt instrument, that is a secured line of credit, granted to an individual with a secured charge registered on title of the homeowner’s property.

It operates in a similar manner to a credit card. That is, you are granted a credit limit in which you can draw down on and use for any particular need and pay down on the line of credit however you choose.  The HELOC requires that interest only be paid on time and when due each month. Unlike an unsecured credit card, a HELOC is secured debt, registered against the individual’s home.

What is a Home Equity Loan?

A Home Equity Loan is a loan, not a line of credit, that is registered against the property. The Home Equity loan is also known as a second mortgage registered on the property. The loan is granted by the lender for an agreed set amount and those funds advanced in full – that is, they will provide you a draft or cheque for all the funds borrowed. The borrower may then use the funds as they require. It is similar to doing a remortgage if your current mortgage is expiring.

There are conditions and terms, for both a HELOC and Home Equity Loan, that are agreed at the time the loan contract is executed.

Some of these are:

  1. Qualification of the loan is firstly dependent on the equity in the home but also on your employment history, income, and credit score. The lender will generally only advance up to 75% to 80% of the value of the property. That is the appraised value of the home less the mortgage owing.
  2. Interest-only payments must be made on a HELOC and paid monthly whereas and interest and principal payments on Home Equity Loan must be paid monthly;
  3. All payments must be on time;
  4. Should the borrower default on his monthly payment, subject to the terms of the loan, the lender may demand the loan in full pursuant to the loan contract signed at the onset. There are often grace periods, but the borrower should always communicate with the lender regarding their situation and understand that missing a payment may affect the interest rate being charged.
  5. In a Home Equity Loan, there is generally a prepayment penalty, therefore if you wish or plan to retire the debt early you should understand the penalty before signing the contract and borrowing the funds.
  6. In a HELOC, there is generally no prepayment penalty if you wish to retire the debt early;
  7. In both, a Home Equity Loan and a HELOC, subject to the terms of the contract, should the borrower default on their payment obligations to the lender, the lender may send a notice of Default and make demand on the full balance. The lender may then begin foreclosure proceedings or sue.

Your home is generally your largest purchase of your lifetime. There are numerous rules in place regarding qualifications at the time of buying the home. Generally, the equity in the home increases when the market value increases and when the mortgage is reduced. At the time of purchasing a property, the borrower has often been preapproved for a mortgage. Mortgages are amortized or spread out over numerous years, often a 25-year repayment period and monthly payments must be made on time each and every month.

Therefore, when it comes to borrowing against the equity, the borrower needs to take this into consideration – why they need to borrow against the equity of the home; the purpose of the borrowings; the risks of borrowing against the equity.

Here are some reasons lenders have used to appeal to borrowers on their webpage:

1. Go on a vacation

2. Buying a car

  • Buying a car and using a HELOC to buy the car is generally an unnecessary risky venture;

3. Consolidate credit card debt

  • It seems to make simple sense, to pay off expensive monthly credit card debt with cheaper secured HELOC debt. Credit card interest rates range but generally 19% with many as high or higher than 30%.  Whereas a HELOC, may be as low as 2.5% or slightly higher depending on prime rate and the individual’s circumstances, but significantly lower interest charged than credit card debt.
  • The risk you run using a HELOC to pay off credit card debt is that now the credit cards have no balance owing they are at risk of being used again for on-going living expenses. The individual needs to understand, set and follow a strict budget. After borrowing, the individual should consider using a cash only approach. Budgets are never fun and often time consuming but the benefits of understanding your spending and correcting this sooner can be very important life skills.
  • You should likely meet with a Licensed Insolvency Trustee prior to considering this. A portion of the home is considered an exempt asset and ownership may be joint. Possibly the debtor should consider a Consumer Proposal in various circumstances rather than borrowing against the home. A debt consolidation mortgage is often a second mortgage on a home and can come with extremely high interest rates and administrative fees.

4. Paying for university or college

5. Home renovations or investing in the market or real estate

  • Borrowing money to buy investments (marketable securities) can be an effective way to boost potential returns but is also very risky. There are tax advantages associated with borrowing money for investments in that interest charges may be deductible for tax purposes. Consult your tax planner prior to borrowing to ensure the borrowing and investment is done correctly.
  • Prior to borrowing money to invest, you should consider:
    • The type of investment, how long you plan to stay invested, and your ability to weather a change in market conditions.
    • Leverage works both ways, it is great when the investment appreciates in value but the risk is great if the investment drops in value and you are forced to divest.
  • Although investing in real estate seems like a sure thing, especially in recent years, this is not always true. As long as real estate is rising this will seem like a great thing but leverage can work in reverse. What happens if real estate drops in value? There can be many unforeseen expenses or downturns.

Have a Plan

One of the most important aspects of borrowing funds for either HELOC or Home Equity Loan is having a plan.  Planning is the key to success.

The plan must address the following:

1. An analysis of current and future cash flow needs before and after you borrow funds; cash flow is the key to all business and personal needs;

2. Be aware of all risks associated with borrowing the funds; ask yourself lots of what-if questions;

3. Think about the risks and the impact on unknown and other possible expenses

  • Future home repairs (new roof, new furnace, water or plumbing problems)
  • Possible health issues (sickness, injury)
  • Loss of employment

4. Understand the timing of the repayment obligations based on monthly obligations of loan and all other debts;

  • Ensure you understand your cash flow obligations.

5. Consider the risk of interest rate changes. While some loans are fixed rate interest, they are usually only for the first 5 years. Often loans are a variable interest rate charge and therefore subject to possible interest rates changes;

  • Historically, the rise in interest rates have been one of the largest causes of debt repayment failure and foreclosures
  • Ensure you understand the sensitivity to the amount of increased payments based on a rise in interest rates

6. The length of time of repayment;

  • Understand the proposed length of repayment in relation to the age and employment status of the borrowers
  • Consideration should be given to two married working parties and future family plans;

To conclude, the concept of either a Home Equity Line of Credit or Home Equity Loan are simple. You borrow money and pledge your home as security. The key before borrowing money is to have a plan. Understand the pros and cons of the venture. Ask yourself tough questions: do we need to borrow the money, is this the right time to borrow money. Prepare a budget and understand cash flow both before, after borrowing the funds and in the future.

If your main purpose is to use the funds to pay down debt you should consider all of your options. At Chase & Associates, we offer a complimentary assessment where we will take a look at your financial situation and provide you with feedback and ideas to consider.

Contact Us

We are qualified as Chartered Professional Accountants (CPAs) and Licensed Insolvency Trustees. We have years of experience in analyzing financial situations and coming up with ideas and solutions. As an independent firm, we have the flexibility to take as long as you need to reach the best solution.  Feel free to contact one of our convenient offices. You will be glad you did!

Stephen Boale, LIT

Prior to joining Derek L. Chase & Associates Ltd. in 2019, I was a founding partner of a boutique insolvency firm in Vancouver. Earlier, I spent ten years practicing exclusively in insolvency matters with a big four chartered accountancy firm. I have also been employed as an Official Receiver with the Office of the Superintendent of Bankruptcy.