Understanding HELOCS

A Home Equity Line of Credit (HELOC) is not a traditional mortgage but a type of revolving credit secured against the equity in your home. Canadians are very creative in their use of HELOCs using them for everything from investing to debt consolidation to using their HELOC as an emergency fund. HELOCs have unique characteristics that make them different from other loan structures, as they usually have a draw period, segments, and various pre-payment options, to name a few.

HELOC Uses

HELOC Characteristics

HELOC Details

Prime Variance and Base Rate

Collateral Mortgage

Property Type

HELOC Segments

Draw Period

Draw Period and the Smith Maneuver

HELOC Uses

Canadians use Home Equity Lines of Credit (HELOCs) for various purposes, taking advantage of the flexibility and accessibility that HELOCs offer. Here are some common scenarios when a HELOC might be used:

• Home Improvements and Renovations
• Debt Consolidation
• Education Expenses
• Investment
• Emergency Fund
• Major Purchases
• Funding Retirement
• Diversification of Investments
• Bridge Financing

Home Improvements and Renovations

HELOCs are often used to fund home improvements and renovations. Since these improvements can increase the value of the home, using the home’s equity to fund them is seen as a financially savvy move. This is one of the most popular uses as it also potentially increases the homeowner’s net worth by enhancing the property value.

Debt Consolidation

HELOCs typically offer lower interest rates compared to credit cards and other types of personal loans. Many people use the funds from a HELOC to consolidate higher-interest debt under a lower rate, which can simplify payments and reduce the amount paid in interest over time.

Education Expenses

Some homeowners tap into their home equity to pay for education costs, whether for themselves or family members. This can include tuition fees, living expenses while studying, or other related costs.

Investment

Using a HELOC to invest in additional property or securities can be a strategic financial move. The Smith Manoeuvre is an example of a sophisticated strategy where Canadians use their HELOC to invest in the stock market, with the intent of growing their assets and potentially deducting the interest on the borrowed money against their income.

Emergency Fund

Some homeowners prefer to have a HELOC set up as a safety net for unexpected expenses, such as medical emergencies or sudden unemployment. Having a HELOC ready for use can provide peace of mind and quick access to funds when needed most.

Major Purchases

HELOCs can be used for major purchases such as buying a car, funding a large event like a wedding, or making significant lifestyle purchases that require substantial amounts of money.

Funding Retirement

Some Canadians use a HELOC as a financial tool during retirement to supplement their income. This can help manage cash flow, especially when other retirement savings may not be sufficient to cover all expenses.

Diversification of Investments

Borrowing against home equity to invest in other avenues besides real estate, like mutual funds or bonds, is another strategy used by some to diversify their investment portfolios and manage financial risk.

Bridge Financing

HELOCs can also serve as bridge financing for homeowners who are in the process of selling one home and buying another, helping to cover down payments or other expenses during the transition period.

Overall, the flexibility and relatively low cost of borrowing make HELOCs an attractive option for many financial needs, but it’s important for homeowners to consider the risks of borrowing against their home equity, including the potential for loss of the home if debts cannot be repaid.

HELOC Characteristics

A HELOC has the following characteristics:

• Interest Rate Type HELOCs typically have a variable interest rate. The rate is usually linked to the prime rate and will fluctuate with changes in the market rates. This is different from fixed-rate mortgages where the interest rate remains the same throughout the term of the loan.
• Open Mortgage HELOCs are considered open mortgages. This means you can pay back the borrowed money at any time without incurring penalties. It offers a flexible repayment schedule, which is a significant advantage for borrowers who might come into additional funds and wish to pay down their debt sooner.
• Term A HELOC does not have a fixed term in the traditional sense that a mortgage does. It often comes with a set draw period (commonly 10 years), during which you can borrow and repay funds as needed. After the draw period ends, you might be required to pay back any outstanding balance, either as a lump sum or over a newly agreed-upon period, sometimes referred to as the repayment period.

HELOCs are a popular choice for those who need flexible access to funds over time, such as for home renovations, education, or consolidating high-interest debt.

HELOC Details

Many lenders who offer the lowest rate HELOCs do so with the requirement that the HELOC be taken with an insured or insurable mortgage with the same lender. Basically, this makes this HELOC a second mortgage, or in second place behind the first mortgage. Often lenders do not allow second mortgages behind their first mortgage. (link describing mortgage places). However, they may in cases where they hold the first mortgage so from their point of view offering the second mortgage or HELOC in this case is really just a kind of blend and extend from their viewpoint.

Presently HELOCs are amortized at 25 years maximum, but given recent changes around amortization length for first-time home buyers (what is this) and buyers of new construction, we may see this changing if the insurers of high-ratio mortgages, like CMHC, Sagen, and Guaranty Canada, provide extended insurance. Stay tuned!

As a HELOC is still a mortgage (either a first mortgage if there is no present mortgage on the property or a second mortgage if there is) you still have to apply for a HELOC much in the same way you have to apply for a regular mortgage. This means you must be able to prove income, have a credit score above 650 or 680 depending on the lender, and have a total debt service ratio of 44% or less. Generally, the criterial for being approved for a HELOC are similar to the criteria required to being approved by a prime lender.

HELOCs have lender determined minimum and maximum amounts depending on the properties value if it is in first position (e.g. $50,000 minimum) or second position (e.g. $10,000 minimum). Maximum amounts are based on the LTV of the appraised value (e.g. 65%), to a lender determined maximum amount (e.g. $1,000,000).

Prime Variance and Base Rate

In the context of Canadian mortgages and Home Equity Lines of Credit (HELOCs), the terms “prime variance” and “base rate” are crucial for understanding how interest rates are calculated.

Base Rate

The “base rate” generally refers to the prime rate in Canada. This rate is the interest rate that commercial banks charge their most creditworthy customers. It is primarily influenced by the Bank of Canada’s overnight rate. Most lending rates for various loans and lines of credit, including mortgages and HELOCs, are based on this prime rate. For instance, as of my last update, the prime rate in major Canadian banks is typically around 6.95%.

Prime Variance

The “prime variance” (sometimes called “prime rate margin” or simply “margin”) refers to the amount by which the interest rate of a mortgage or a HELOC is above or below the prime rate. This variance is added or subtracted from the base rate to determine the final interest rate charged on the loan.

For a HELOC: The rate might be expressed as “Prime + 0.50%,” meaning the interest rate on the HELOC would be 0.50% higher than the current prime rate. If the prime rate is 6.95%, the HELOC rate would then be 7.45%.

For Adjustable or Variable Rate Mortgages: These products also typically follow a similar structure, with the rate being a certain percentage above or below the prime rate depending on the lender and the specifics of the mortgage product.

These terms are used by lenders to establish the interest rate you pay on borrowed funds. The variance allows financial institutions to manage risk while offering competitive rates to different customers based on their creditworthiness and other factors. In practical terms, knowing the prime rate and the variance applied by your lender can help you calculate and anticipate changes in your interest payments, especially important for budgeting in variable rate loans where rate fluctuations directly affect your monthly payments.

Collateral Mortgage

Because a HELOC is a line of credit and not a conventional mortgage, it is registered on title as a Collateral Mortgage and registered for 100% of the property’s appraised value.

Property Type

A HELOC cannot be placed on just any property but on properties that conform to the requirements of the lender, such as:

• Owner occupied (the person who is on title and holds the HELOC must actually live there) (but there can also be people renting a unit of the property).
• Maximum of 4 units
• Must meet minimum square footage if the property is a condo (ie., 600 square feet)
• Must meet minimum square footage if the property is a home (ie. 900 square feet)
• Rural properties on exception and only if the size is less than 10 acres

HELOC Segments

In Canada, some Home Equity Lines of Credit (HELOCs) offer a unique structure that combines both a traditional line of credit segment and an amortizing segment. Here’s what each segment entails:

Line of Credit Segment

The line of credit segment of a HELOC functions as a typical revolving credit line offering borrowers access to funds, the possibility of interest-only payments, and the benefit of a variable interest rate.

Borrowers can draw funds up to a certain limit, repay them, and borrow again during the draw period.

Typically, during the draw period, you may only be required to pay the interest on the amount you borrow, not the principal. This allows greater flexibility in managing cash flow.

This part of the HELOC usually has a variable interest rate based on the prime rate (base rate) plus a margin (prime variance) determined by the lender.

Amortization Segment

The amortization segment functions more like a traditional loan and is sometimes referred to as a “readvanceable mortgage” when paired with a HELOC. This segment requires regular payments that cover both interest and principal, thus reducing the balance over time. It has a set amortization period, which means the loan will be fully paid off at the end of the term if all payments are made as scheduled. The interest rate on this segment can be fixed or variable, depending on what the borrower has agreed upon with the lender.

Integrated Functionality

In a HELOC with both segments, the borrower enjoys interlinked limits and flexibility.

As you pay down the principal on the amortizing segment, the credit limit on the line of credit segment may increase, giving you access to more revolving credit (interlinked). This feature is particularly useful in strategies like the Smith Manoeuvre, where the borrower aims to convert home equity into investment capital.

This structure provides the borrower with both the flexibility of a line of credit for immediate, variable needs and the stability of a term loan that has a clear repayment schedule.

Why Use Both?

The dual-segment approach can be advantageous for homeowners who want the flexibility to access their home equity for various needs while simultaneously reducing their overall mortgage debt over time. It’s also beneficial for managing cash flow more effectively, as the amortizing segment helps in gradually reducing the debt, and the revolving segment can be used for ongoing or unexpected expenses.

For those considering this kind of HELOC, it’s important to understand all terms and conditions, how interest is calculated on each segment, and how payments are applied. This understanding will help in effectively managing both segments to fit personal financial strategies.

Draw Period

The “draw period” of a Home Equity Line of Credit (HELOC) refers to the time frame during which you can borrow against the credit line. During this period, you can withdraw funds up to your credit limit as needed, repay them, and borrow again.

Key Characteristics of the Draw Period

• Length The typical length of a draw period for a HELOC in Canada is usually around 10 years, but it can vary depending on the lender and the specific terms of the HELOC.
• Access to Funds During the draw period, you can access the funds in your HELOC through various means such as writing checks, using a debit card linked to the line of credit, or transferring the money directly to your bank account.
• Interest-Only Payments Often, during the draw period, borrowers are only required to make interest payments on the amount they have borrowed. This makes the HELOC particularly flexible and attractive for managing cash flow, though it means the principal amount may not decrease unless voluntary principal payments are made.
• Variable Interest Rates As discussed earlier, HELOCs typically have variable interest rates based on the prime rate plus a margin. This means that your interest costs can change as market rates fluctuate.

After the draw period ends, you enter the repayment period, where you are typically required to start paying back both the principal and the interest. Some HELOCs may require a balloon payment at the end of the draw period, where the entire balance is due, or may convert to a loan with regular amortizing payments over a new term. It’s important to understand these terms when you enter into a HELOC agreement, as they can significantly affect your financial planning.

Draw Period and the Smith Maneuver

The possibility of extending the draw period of a Home Equity Line of Credit (HELOC) while implementing the Smith Manoeuvre or for any other reason typically depends on the specific terms set by the lender and the agreement made when the HELOC originated.

Factors Influencing the Possibility of Extending the Draw Period:

• Lender’s Policy Each lender has its own set of policies regarding HELOCs. Some may offer the option to renew or extend the draw period, while others may not. This usually involves a review of the borrower’s current financial situation and creditworthiness.
• Contractual Terms The original terms of the HELOC agreement may include clauses related to renewing or extending the draw period. It’s important for borrowers to review their loan documents or speak with their lender to understand what options are available under their specific HELOC.
• Financial Position If a borrower has maintained a good payment history and their financial situation has remained stable or improved, lenders might be more willing to consider extending the draw period. This is because the risk associated with extending more credit is mitigated by the borrower’s proven reliability.
• Real Estate Market Conditions If the value of the home has increased significantly, the lender might be more inclined to extend the draw period, as the increased equity in the home reduces the lender’s risk.

Specific to the Smith Maneuver

When using a HELOC for the Smith Manoeuvre—a Canadian financial strategy designed to convert non-deductible residential mortgage interest into deductible investment loan interest—the draw period is particularly crucial. The strategy involves regularly reborrowing the equity paid down on the mortgage to invest in income-producing vehicles. An extended draw period could allow for greater investment flexibility and enhance the tax benefits over a longer time.

For those using the Smith Manoeuvre, it may be advantageous to negotiate the terms of the HELOC with the lender upfront, including the possibility of an extended draw period. Some financial institutions may be more accommodating to modifications if they understand the strategic use of the HELOC in this way.

If you’re considering using a HELOC for the Smith Manoeuvre or for another long-term financial strategy, it’s essential to discuss your plans and needs with me. I can provide guidance on whether an extension of the draw period is possible and under what conditions.

Summary

Understanding Home Equity Lines of Credit (HELOCs) reveals their multifaceted applications and distinct advantages for Canadian homeowners. These financial tools are not just alternative borrowing options but strategic assets that can significantly impact financial planning and wealth management.

HELOCs offer a flexible, revolving credit source, making them ideal for immediate liquidity needs such as home renovations, education expenses, or emergency funds. Their ability to fund substantial investments or facilitate significant purchases underscores their utility in achieving larger financial goals. Moreover, the use of a HELOC for strategies like the Smith Manoeuvre showcases its role in sophisticated financial planning, allowing Canadians to transform non-deductible residential mortgage interest into deductible investment loan interest, thus potentially enhancing their long-term financial portfolio.

The characteristics of HELOCs, such as their variable interest rates tied to the prime rate and the flexibility of repayment terms through open mortgage structures, provide borrowers with control over their debt management. This control is crucial in adapting to personal financial situations and market conditions. The dual-segment structure of some HELOCs further enriches this tool, offering both the spontaneity of a line of credit and the stability of an amortizing loan.

However, the versatility of HELOCs comes with the need for prudent management. The potential risks of borrowing against home equity, such as the risk of losing one’s home if unable to repay the debt, necessitate a balanced and informed approach to using HELOCs. It’s essential for homeowners to understand the terms of their HELOC agreement, including the impact of interest rate changes and the implications of the draw and repayment periods.

In conclusion, while HELOCs provide substantial financial leverage and flexibility, they require careful consideration and management. For those considering a HELOC, whether for immediate financial needs or long-term strategies like the Smith Manoeuvre, it is crucial to consult with financial professionals to fully understand the benefits and responsibilities involved. This ensures that the use of HELOCs aligns with personal financial goals and market conditions, securing not just immediate financial needs but also future financial health.

Allen Ehlert is a licensed mortgage agent specializing in real estate finance, financial strategy, underwriting, and investing. He provides independent consulting for companies and governments, including the Ontario Real Estate Association, Deloitte, the City of Toronto, Enbridge, and the Ministry of Finance.

Allen Ehlert is part of Mortgage Outlet. Mortgage Outlet is an independent boutique mortgage brokerage providing concierge financial services to its clients. Mortgage Outlet does over one billion dollars of mortgage underwriting each year. Mortgage Outlet agents are frequently relied on by the media (BNN, CP24, Financial Post, etc..) to provide on-camera professional insight.

Allen Ehlert, Mortgage Agent Level 1

Mortgage Outlet Inc., License # 12628