Understanding Home Equity Mortgages and Loans

If you are planning a large expense or are looking to consolidate high-interest debt, your home can be an excellent source of funding. By taking out a loan against your home’s equity, you can quickly access a lump sum of cash at relatively low interest rates on either a fixed or variable term.

Indeed, a home equity loan appears to be an excellent option for homeowners looking to tap into their home’s equity—but what exactly is it, and how does it work? Read on to learn more.

What is a Home Equity Loan?

A home equity loan, also commonly referred to as a home equity mortgage, allows homeowners to borrow funds against the equity held in their homes. The exact loan amount is based on the available home equity, which can be calculated as the current market value of the home minus the mortgage balance due.

Types of Home Equity Mortgages

Home Equity Line of Credit (HELOC)

A HELOC is a revolving line of credit based on the equity you have in your home. It functions similarly to a credit card: you can borrow up to a certain limit, pay it back, and borrow again as needed. One of the main benefits is flexibility, where you can borrow as much or as little as you need. It is an open product allowing you to make the minimum monthly interest-only payments or pay it off quickly without penalty. Most HELOCs have adjustable interest rates, which means the rate can fluctuate over time based on the prime rate.

Second Mortgage

A second mortgage is an additional loan taken out on a property that already has a primary mortgage. Unlike a HELOC, a second mortgage usually provides a lump sum of money that is repaid over a set period with regular monthly payments. These loans can have either fixed or variable interest rates. However, it is important to note that interest rates are typically higher than those on the primary mortgage because the lender’s risk is higher.

Reverse Mortgage

A reverse mortgage allows homeowners aged 55 or older to convert part of the equity in their home into cash. Borrowers do not have to make monthly mortgage payments. Instead, the loan is repaid when the borrower sells the home, moves out permanently, or passes away. Funds can be received as a lump sum, in monthly installments, or a combination of both.

Collateral Mortgage

A collateral mortgage allows the lender to secure the mortgage against the property for a higher amount than the actual loan, providing flexibility for future borrowing. This means you can borrow more in the future without needing to refinance or incur additional legal costs. Accessing equity through an existing collateral charge will require you to re-qualify with the lender.

How Does a Home Equity Loan Work?

A home equity loan is a type of secured debt, with your home’s equity used as collateral.

Determining the Loan Amount

A home equity loan is secured by a homeowner’s equity in the property, which is calculated as the difference between the property’s value and the remaining mortgage balance. For instance, if your home is currently valued at $650,000 and your remaining mortgage balance is $400,000, the accumulated equity in your home equals $650,000 – $400,000 = $200,000.

Most lenders limit the home equity loan amount to no more than 80% of the total value of the equity. This means that if your credit score is good and you otherwise qualify, you will be able to borrow up to $160,000 through a home equity loan based on the equation above.

The Repayment Process

Repayment options are similar yet different to traditional mortgages and can be varied depending on the loan type you secure. For example, a line of credit require monthly interest-only payments. Home equity loans may also follow a one to five-year fixed or variable term, with an amortization period of between 25 and 30 years, a portion of the payment is applied to interest and the remaining pays down the principal.

Home Equity Loan Rates

With home equity lines of credit, the interest rates are tied to the prime rate set by the Bank of Canada. This rate at the time of loan approval will be based on Prime plus or minus a discount or premium, for example, Prime +.50%, and has a direct impact on the interest rate offered to you. It can fluctuate up or down as the prime rate changes. 

Interest rates for Home Equity Loans on fixed terms are determined by bond yields with comparable terms and have been historically priced 1-2% higher than bond yields. Once you choose a fixed term, the rate and payments are set for the entire term and do not change.          

Furthermore, your credit score, loan term, and LTV ratio will determine where your personal rate falls within the possible interest rate range.

Tax Implications of Home Equity Loans 

In Canada, the tax implications of home equity loans largely depend on how the funds are used. For instance, if the loan is secured against a primary residence and used for personal expenses like higher education or home renovation, the interest payments will be non-tax-deductible.

On the other hand, if the loan proceeds are used for income-producing activities like purchasing rental properties or other types of investments, the interest may be eligible for tax deduction. Ensure that you keep clear documentation of the funds’ usage and carefully review any terms and conditions set by the Canada Revenue Agency. Home Equity Loans can also be a great way to supplement income through retirement, as accessing equity is not taxed as income.

Qualifying for a Home Equity Loan 

Qualifying for a home equity loan in Canada is relatively easy. Nonetheless, lenders evaluate a few factors when determining whom to extend the funds to:

• Home equity: Of course, the amount of a home equity loan you may qualify for will depend on the equity accumulated in your property up to date. The lender may order a property appraisal to evaluate the current market value of your home, which is necessary to calculate the equity amount.
• Credit score: Lenders use credit scores to assess the borrowers’ creditworthiness. Most lenders prefer borrowers with good to excellent credit scores, typically 650 or above.
• Debt-to-income ratio: The debt-to-income (DTI) ratio is used to evaluate your monthly debt payments against your gross monthly income. Most of the time, your DTI must not exceed 43% if you wish to take out a second mortgage.
• Reliable income: Another key factor lenders consider when evaluating home equity loan applications is a stable and reliable income, which must be supported by tax returns, pay stubs, or bank statements.

When Should You Consider a Home Equity Loan?

A home equity loan is a great option for borrowers looking for a single lump-sum payment to fund expenses associated with home renovations, education, debt consolidation, retirement, or emergencies. If you have accumulated significant equity in your home, taking out a home equity loan will provide you with the necessary funds at lower interest rates as compared to many of the other financing options, including lines of credit or unsecured loans.

Home Equity Loans vs. HELOCs

Similarly to a home equity loan, a HELOC, or home equity line of credit, will use the equity in your home as loan collateral. However, a HELOC is a revolving line of credit, meaning that you can draw funds as you need them, pay them back, and then draw funds again. The minimum monthly payment required is the interest; you are only charged interest on the amount you have borrowed and can pay it back as fast as you like without penalty to reduce interest costs.

A home equity loan, on the other hand, is a single lump-sum payment to the borrower, which must be repaid over a set period of time at a predetermined interest rate. Home equity loans typically have fixed interest rates, while HELOCs have variable rates.

Advantages of a Home Equity Loan

Overall, home equity loans can be a valuable tool for responsible borrowers. They provide an easy source of cash with relatively low interest rates and possible tax deductions.

• Simple qualification process: Equity loans are secured by equity in your home and are relatively easy to get approved for. The lender will require an appraisal of your property to determine current value and the equity available, a reveiw of the application and credit check to determine qualifications and product options.

• Relatively low interest rates: While the second mortgage on your property will have higher interest rates than your original mortgage, they will still be relatively low, especially when compared to other borrowing options like credit cards or lines of credit. It can also allow you to keep a previous low rate on your current first mortgage and avoid having to pay a costly penalty to break your current mortgage.

• Lump-sum payment at closing: When your home equity loan closes, you will be guaranteed to receive a predetermined lump-sum payment. This payment can then be used for large, expensive goals like paying for higher education, remodelling the home, or consolidating other debt.

Disadvantages of a Home Equity Loan

The main disadvantage of a home equity loan is that it seems too good to be true. Many times, borrowers will fall into the cycle of spending, borrowing, spending more, borrowing more, and perpetually sinking more and more into debt. When applying for a home equity loan, you may be tempted to start a habit of “reloading” or taking out a loan to pay off existing debt, free up additional credit, and use it to make more purchases. Plus, you may be tempted to take out more funds than you immediately need.

Key Takeaways and Considerations

Without a doubt, a home equity loan can be an excellent source of cash for homeowners looking to cover large expenses with a lump-sum amount. With relatively low interest rates and a simple qualification process, taking out a second mortgage on your home may be just the right solution you’ve been looking for to finance your home renovation, cover your children’s university expenses, or consolidate higher-interest debt. 

Nonetheless, home equity loans are not a one-size-fits-all solution and require extensive research and due diligence before application. Contact The Mortgage Advisors today to learn more about your financing options.