The home equity line of credit: a practical product to be used with caution
What is a home equity line of credit?
Rather than take out a mortgage loan with regular payment, you can set up a line of credit which allows flexible payments and give you access to the reimbursed money. At the time of purchase, the financial institution will set up a line of credit. “Although you only need a 20% down payment to obtain this type of credit line, it only represents 65% of the financing with 15% taking the shape of a conventional loan (fixed rate and term for a period of 1 to 5 years, renewable),” says Stanislas Martell, Sales Manager, Specialized Network, at the National Bank.
“After a few years of repayment, this money can be reused for various projects,” explains Louis-François Ethier, Mortgage Director with National Bank.
For example, let’s say someone purchases a $200,000 home with a 35% down payment, and takes out a 25-year home equity line of credit for $130,000 (at 3.39% with a five-year term). After making monthly payments of $642 over five years, they’ll be left with $111,937 to repay, and an available balance of approximately $18,063. Note: The amounts stated are hypothetical; actual payments may vary.
How can the home equity line of credit be used?
“This amount can be used for any type of need,” shares Stanislas Martell, “a trip, renovations, the purchase of a car, etc.”
The home equity line of credit can also be divided into several bank accounts, to which a salary can be transferred, withdrawals can be made with a debit card, etc. “Specifically, this saves on banking fees,” clarifies Stanislas Martell.
What are the advantages of a home equity line of credit?
“Control and flexibility,” Stanislas Martell answers with no hesitation. “Clients can borrow up to 65% of their home’s value in available funds, and they have control over the payments,” he continues.
It is also an easy way to obtain credit—since there is no need to make another credit request—and to get it at a low cost because “home equity lines of credit have some of the lowest interest rates on the market,” shares Louis-François Ethier.
Is it possible to use this product for tax avoidance?
Although every situation is different and should be discussed with a tax consultant and/or an accountant, “the home equity line of credit can have certain tax advantages,” notes Stanislas Martell. Business owners can use it as part of a cash damming strategy. It is then a question of transforming interest that is not deductible (such as the one paid on a residential mortgage) into deductible interest.
Another strategy is using the line of credit to invest. In this case, the interest is tax deductible under certain conditions. A financial planner is aware of these conditions and can advise clients.
What are the risks associated with the home equity line of credit?
The main risk is that the buyer does not need to make payments to reduce the capital. In fact, since only the interest must be paid, a careless consumer could still have the entirety of the capital left to repay when the time comes to sell the house.
Finally, since the interest rate of the home equity line of credit is variable, it can increase during the loan period and make repayment more difficult.
To limit the risks, it is possible to integrate a fixed-rate mortgage with regular payments being made to the home equity line of credit. There are also safeguards in place since the consumer can only use the funds for other projects as long as the loan capital is being repaid.
What is the difference with a reverse mortgage?
With a home equity line of credit, the capital does not need to be repaid regularly, whereas the interest is due immediately. In the case of a reverse mortgage, neither the interest nor the capital needs to be repaid right away. Both will only be paid when the home is sold or at the time of death.
This product, which generally has a higher interest rate than that of a home equity line of credit, caters to people 55 years and older. It can help with living expenses or be used to finance projects at an age where financial resources are sometimes scarce. This amount can be used for any needs the real estate owner may have.
“The reverse mortgage is primarily a tool used to generate a monthly cash flow or acquire a lump sum based on the value of the property. This amount does not exceed 55% of the home’s value. This type of loan takes the form of a contract with the institution financing the reverse mortgage,” explains Stanislas Martell.
In which situations is a home equity line of credit recommended?
“It can be a useful product for self-employed individuals or any other person whose income is variable and not regular. They can make higher payments when they receive a larger sum and pay only the interest during periods where less money is coming in,” explains Stanislas Martell.
In fact, this product mainly caters to buyers more mature than usual. “A down payment of at least 20% is needed because it requires stricter discipline to regularly pay the capital in order to reduce the debt,” concludes Louis-François Ethier before cautioning: “The home equity line of credit is not suited to first-time buyers or those lacking financial discipline.”
Understand the importance of considering all the factors that can influence your decision before taking advantage of the home equity line of credit.