Home Equity Loan vs HELOC
Compare two options for accessing home equity side-by-side.
Home is where the heart is, but for most Canadian’s it’s also the heart of your investment portfolio. It’s a valuable asset that you can strategically use to your advantage. You just have to make sure you take steps to protect that investment.
Otherwise, you increase your risk of foreclosure or power of sale. This is what you need to know when comparing a home equity loan vs HELOC.
What is a home equity loan? What is HELOC?
A home equity loan is a fixed-rate loan that allows you to borrow against the equity built up in your home. You receive a lump sum of cash that you pay back in installments. (It’s not revolving in nature like a credit card or HELOC.) You generally must pay another round of closing costs to take out the new, fixed interest rate loan.
A home equity loan is also referred to as a second mortgage. That’s because it comes in second position behind the mortgage you already have on your property. As such, it almost always comes with a higher interest rate because there’s a higher level of risk for the mortgage lender. If you were to default (fail to repay) your mortgages, there may not be enough equity left after the home is sold to pay both lenders.
To help mitigate this risk, mortgage lenders often limit the amount you’re able to borrow by way of a second mortgage. The government has also mandated rules in terms of the maximum amount you can borrow as a second mortgage. You can borrow up to 80 percent of your home’s appraised value, first and second mortgage combined. (Although based on the level of risk, mortgage lenders may offer you a lesser amount. You must also have the household income to qualify to borrow this amount.)
With a second mortgage, it’s important to recognize that you may need to make fully amortizing payments. This means you have to make regular payments that compromise of both principal and interest. There are second mortgages with offer interest-only payments. This can help from a cash flow perspective, but won’t help you repay your debt. It’s only a short-term solution. You’ll want to have an exit strategy.
By contrast, a HELOC is Home Equity Line of Credit. Instead of taking out the full amount at once, you have an open credit line you can borrow against during a withdrawal period. There’s still a set limit to how much you can withdraw, but you take the funds out as needed by using regular banking methods anytime before the withdrawal period ends.
In general, most HELOCs are adjustable rate financing tools. You’re typically able to make interest only payments to start. Although the lender can always ask you to start paying back the principal at anytime. (Although it is possible for you to make interest-only payments indefinitely. Your estate would have to pay back the money if you passed away with money still owing on your HELOC.)
Some HELOCs are readvanceable in nature. This means that as you make your regular mortgage payments, more space opens up on your HELOC. This can save you the time and the money of setting up a new HELOC if you reach your HELOC borrowing credit limit, although it can also be tempting to spend the new space you have available. This could lead to you racking up further debt.
Otherwise, you can just have a standalone HELOC that’s not linked to your mortgage that’s not revolving in nature. It depends on what you want and what the lender offers.
Home equity loan vs HELOC: A side-by-side comparison
|Home Equity Loan||HELOC|
|Fund disbursement method||Single lump sum||Withdraw from credit line as needed|
|Monthly payments||Fixed installments, covering principal plus interest||Interest-only for 10 years, then payments balloon|
|Interest payments tax deductible?||Yes||Yes|
|Increased foreclosure risk?||Yes||Yes|
One of the biggest advantages of a HELOC is the ability to borrow only the funds you need. With a home equity loan you receive all the money at once. A home equity line of credit allows you to withdraw only what you need. This can be more useful, especially depending on what you want to use the funds to do.
For example, let’s say you want to use your home’s equity to fund a renovation project. If you take out a loan, you may not end up using all the funds you took out.
Or worse, you may go over budget and not have enough money. With a HELOC, you can withdraw money as the project progresses. This avoids overages and undercutting your budget.
Comparing the cost of a home equity loan vs HELOC
A HELOC generally costs about the same to set up as a home equity loan. In both cases you’d need to cover the closing costs. Closing costs generally range from 3-5% of the amount financed. Examples include appraisal fees, title search, title insurance and legal fees.
A HELOC may also start out with a lower interest rate, because the rate is adjustable. However, you have to worry about economic fluctuations. If the government raises benchmark interest rates, the rate on your HELOC almost always increases, too.
With a home equity loan, you lock in the rate at the time you take out the loan. You don’t have to worry about market fluctuations.
This means that the total cost of a HELOC is difficult to assess ahead of time. If rates stay low, then the cost of a HELOC overall may be less. But only if rates stay low. With home equity loans, you can at least know what the total cost will be upfront.
Payments can become a burden
Another advantage of a home equity loan is you never have to wonder what your payments will be next year. You pay off principal and interest from the outset. The payments stay fixed from the first to the last.
On the other hand, home equity lines of credit are interest-only. That keeps your initial payments low, but the lender can always ask you to start making principal and interest payments. These monthly payments may bust your budget.
And remember, HELOC interest rates adjust with the market. Lenders typically adjust the interest rate you’ll pay on your HELOC based on the individual lender’s prime rate. If interest rates start moving up more quickly than you anticipated, this can lead to a risk of default and subsequent foreclosure and power of sale actions by the lender.
Repaying HELOC principal earlier
It’s important to note that you can choose to make a principal repayment during the withdrawal period. This will reduce next month’s interest expense and increase the available credit line during the draw-down period. It also may minimize the amount you need to repay once with withdrawal period ends.
Once it does, the loan payment typically becomes self-amortizing over the remaining loan term. That means that the minimum monthly loan payment is no longer interest only. The payment is sized so that monthly payments over the remaining loan term are large enough to both cover the interest expense and to pay off the loan.
If you have a HELOC with a 20-year term and a 10-year draw, after 10 years the loan becomes self-amortizing over the remaining 10-year repayment period and you can no longer draw against the line of credit.
Passing the stress test
Something else important to note is that you’re often required to pass the mortgage stress test when applying for a home equity loan or HELOC. You’ll need to be able to prove that you can afford to make payments at a rate that’s higher than your actual mortgage rate.
The mortgage lender will make you qualify at the greater of your mortgage rate plus two percent or the Bank of Canada conventional five-year mortgage rate.
Due to the stress test you may not be able to qualify to borrow as much money as you had hoped (or you may not qualify at all).
Always keep foreclosure and power of sale risk in mind
Whether you take out a home equity loan or HELOC, it’s important to understand both increase your foreclosure and power of sale risk. Your home is the collateral used to secure the financing you receive. So, if you fall behind on the payments, the lender is within their rights to start a foreclosure or power of sale action. That’s true for a home equity loan, as well as a home equity line of credit.
As far as which option has a greater risk of foreclosure and power of sale, it depends. The financial burden of a home equity loan is higher overall. The monthly payments that cover both interest and principal may burden your budget.
However, once you get used to making the payments, your budget should balance out. Unless you lose your job or have a major life event, there should not be an issue.
With a home equity line of credit, the burden upfront may be less. Most people don’t have any issue with a HELOC when it’s interest-only. However, you may hit a financial cliff in 10 years once you start to repay the principal.
Pros and cons of HELOCs
- It’s simple to access available credit as needed.
- The interest rates on HELOCs are usually lower than other credit types (i.e. unsecured loans and lines of credit).
- You’re able to make interest-only payments if you choose to, making it easier on your cash flow.
- You can repay your HELOC in full at anytime without paying a penalty.
- You’re able to borrow as much as you want up to your credit limit.
- HELOCs are flexible. You can set one up based on your own individual borrowing needs.
- You’re able to use a HELOC to consolidate debt.
- You’ll need to be financially disciplined to pay it off. In most cases you’ll only need to make interest-only payments to start.
- You’ll also have to be able to avoid the temptation to dip into your HELOC for everyday frivolous purchases, otherwise, you could be paying off debt for a long time.
- It can make it tougher to switch to another lender since not all lenders offer HELOCs. Because of it you may have to pay a higher mortgage rate.
- Your lender can foreclose or initiate a power of sale on your home if you’re delinquent on your payments.
- Since a HELOC’s interest rate is most often variable, your payments could increase at any time.
Your lender has the right to reduce your credit limit at any time (although advance notice must be provided).
- A HELOC is a callable loan. As such, your lender could ask you to pay it back in full at any time.
- You could hurt your credit score if you don’t make at least the minimum payments.
Pros and cons of home equity loans
Home equity loans share a lot of similarities to HELOCs. That being said, here are some of the pros and the cons specific to home equity loans.
- It can be a good way to consolidate high interest debt.
- Since the payments are usually fully amortizing, you’re forced to make principal and interest payments. This means that you’re working towards debt freedom.
- You can use the money as you see fit. You could pay for home renovations, your child’s education or toward your adult child’s down payment on their first home.
- It’s available at a lower interest rate than other forms of debt (i.e. credit cards and personal loans).
- If you’re able to take out a home equity loan with your existing lender, you won’t have to pay a mortgage penalty to set one up.
- The interest rate on a home equity loan is almost always higher than your mortgage interest rate since it’s in second position, posing more risk for the lender.
- The initial out of pocket expenses of a home equity loan is usually a lot more than a personal loan.
- You’re using your home as collateral. That means if you have difficulty at any point repaying your home equity loan, your lender could foreclose on your home or initiate a power of sale.
- You don’t need perfect credit to qualify. Lenders are more concerned about how much equity you have in your home. As long as you have enough equity, you shouldn’t have any trouble qualifying for a home equity loan.
Home equity loan and HELOC alternatives
Before signing up for a home equity loan or a HELOC, it’s important to evaluate alternatives to see if there’s a better solution.
One alternative is a reverse mortgage. A reverse mortgage can make sense when you don’t have the income to qualify for a home equity loan or HELOC.
If you’ve made prepayments (extra payments) against your mortgage, your mortgage lender may let you reborrow those funds. This may be a good way to avoid the closing costs of a home equity loan or HELOC and borrow funds at a lesser interest rate. You won’t know unless you ask, so be sure to inquire with your lender if this is an option you’re considering.
Then there are other alternatives like taking out a personal loan or borrowing money from family.
Each should be carefully evaluated before deciding on the debt repayment solution that’s right for you.
Always consult a mortgage professional before you borrow!
If you want to access equity in your home, always consult with a professional first. You can call 1-844-402-3073 to speak to a counsellor at no charge. Together, you can review your budget and decide on the best option for your finances moving forward.
Do you want to learn more about the pros and cons of personal loans, the pitfalls of making interest only payments, and improving your credit score?
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