I was speaking with a friend who recently switched over from a mortgage to a line of credit product; she was surprised she hadn’t done it sooner. It got us talking about the differences between the typical mortgage product and a home equity line of credit. While both have advantages, the line of credit can take the lead if used properly. Below are 7 signs a home equity line of credit is the perfect financing vehicle to assist you in achieving your home ownership goals.
You have sufficient home equity available
As the mortgage rules changed in 2012, a home equity line of credit product limit cannot exceed 65% of the current home value. If a borrower wants to borrow more than the maximum, any portion above the 65% must be in the form of a mortgage product.
You don’t mind a little risk regarding interest rates
The interest rate for a home equity line of credit is based on the prime rate, which the Bank of Canada meets to discuss every 6 weeks, or 8 times a year. Presently the prime rate is at 2.70% and has remained unchanged since late 2015. We currently have access to a line of credit at 3.20%, or prime plus 0.50% with some lenders, while other lenders are pricing it at prime plus 1% (3.70%). While the interest rate on a line of credit is currently higher than a fixed rate mortgage term, there are other benefits that justify the rate difference and the interest rate is still lower than a credit card or open mortgage term.
You don’t want a payout penalty
A line of credit is a great option if you are unsure how long you’ll need the funds for, or you don’t want to commit to a closed fixed mortgage term. As a home equity line of credit comes with an open term, there is no fee to completely pay off the balance. This applies for any large pre-payments too, which allows you to payoff large amounts of the principal with no fees or costs at any time. This is unlike a traditional closed mortgage term that has maximum pre-payment privileges and a payout penalty if you break your term early.
You can practice payment diligence
Line of credit products have a minimum payment; the amount is usually the cost of interest only. A $100,000 line of credit balance would cost about $263 per month, interest only. Be aware if you are only paying interest on the balance, the outstanding principal is never going down.
If maximizing home equity is your goal, it’s important to have a re-payment plan that sets your monthly payments above interest only so they actively reduce the line of credit balance. Irresponsible line of credit management can lead to a revolving wheel of debt that never stops, forcing the borrower into a fixed mortgage term with predictable repayment, or worse.
You can handle a revolving balance
Speaking of balances, when you pay down the principal on a home equity line of credit, you can re-use it. It can act as an advanced tax strategy, a resource for investment growth, a source of downpayment for the purchase of a rental property, or a means for debt management. If used effectively, a line of credit can be a great tool in your financial portfolio, as long as you don’t let the balance get to a point where it’s too expensive to reduce. This could be a reality if prime rate rises rapidly and the interest only payment becomes so high that it’s unaffordable, or you’re unable to make minimum payments as well as reduce the line of credit balance at the same time.
You understand the benefits of using an all-in-one product to consolidate for interest savings
There are a few line of credit products that feature multiple components; you can use a portion for your car loan, a portion to consolidate your credit card balances, a portion for day-to-day spending, and the remaining portion to pay off your existing mortgage balance. Under this product type, you could have savings along with your pay cheques deposited to a related bank account which would be “credited” towards your total outstanding debts, this is impactful as interest costs are calculated monthly on a line of credit. This can still be a great strategy to achieve your financial goals, as long as you can remain diligent with your spending and repayment habits.
You are a strong borrower with a nice property
The qualifying guidelines for a home equity line of credit product are strict. Lenders are looking for sophisticated borrowers who have a great credit score, strong credit history, verifiable income with all required documents and a very marketable property. The reasoning behind this is lines of credit are higher risk; they can easily go wrong if not used properly, unlike a mortgage that has fixed repayment terms based on amortization.
You can use a line of credit for either a purchase or refinance, and above are only a few of the benefits it can offer. Before committing to any large debt, ensure you understand all of the fine print. If you’re unsure if a line of credit product is right for you, have a detailed conversation with an experienced mortgage professional, or explore a combo product that features a line of credit limit that becomes available as you pay off your mortgage balance.