What’s a HELOC and how does it work?

For homeowners who need cash for renovations or debt consolidation, a home equity line of credit (or HELOC) typically offers credit at a lower interest rate than other types of (unsecured) loans. That’s because the loan is secured by the home, so if you default on HELOC payments, the lender may choose to foreclose. Credit cards and other credit lines have higher interest rates but don’t carry the risk of foreclosure.

Essentially, a HELOC lets you borrow from the home equity you’ve built up through mortgage repayments and/or appreciation of the home’s value. Some mortgage lenders require that you borrow at least $10,000 to $25,000 to take out a HELOC, while others have no required minimum.

A HELOC is generally an option for borrowers who have at least 20 percent equity in their home and meet the lender’s qualifications (which usually means steady income, a good credit score and a desirable property). However, a HELOC only gives you access to a maximum of 65 percent of your home’s value.

For instance, let’s say your home’s value is $400,000 and your outstanding mortgage balance is $250,000. Your equity is equal to 37.5 percent, which is well above the 20 percent threshold. The maximum loan to value ratio is 80 percent ($400,000 x .8 = $320,000). Subtract your mortgage balance to determine your maximum allowable HELOC amount: $70,000. ($320,000 – 250,000 = $70,000). This is well below 65 percent of the home’s value, so in this scenario, you could borrow up to $70,000, assuming you met the lender’s criteria. In fact, you could typically borrow part of that amount (say for a renovation) and then borrow more later (if your renovations go over budget) without writing up a separate loan document.

The Canadian Association of Accredited Mortgage Professionals estimates that about 2.2 million Canadian homeowners have HELOCs. Some Canadians are even using HELOCs in place of an emergency fund, since savings accounts pay such little interest nowadays. That said, HELOCs arebest suited for disciplined borrowers, since it’s possible for borrowers to get in over their heads and potentially lose their homes. The other key thing to keep in mind is that you may lose your option to take out a HELOC if the lender decides you’re too much of a risk, perhaps because you’ve taken out a lot of credit in other areas or your home has depreciated in value. Talk to your mortgage broker if you’re unsure of whether a HELOC is right for you or how it might work in your situation.

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