Understand the HELOC basicsOne of the nicest things about homeownership – aside from having a roof over your head – is that every month that you make your mortgage payments you build up equity in the property. Build up enough equity and you can consider withdrawing some of it in a home equity line of credit (HELOC) to fund renovations or make some other form on investment. Here are some of the advantages – and potential dangers – of tapping into your equity.

The Basics

As mentioned above, a HELOC is a loan that’s based on the amount of equity you own in your home. In the past, banks could offer you as much 80 per cent of the loan-to-value ratio of your property, minus the remaining balance you owe on your mortgage. However,  recent changes to Canada’s banking regulations have reduced that amount to 65 per cent.

Say, for example, your house has an appraised value of $400,000. Sixty five per cent of that is $260,000. If you owe $200,000 on your mortgage, you would qualify for a $60,000 HELOC.

How to Apply for a HELOC?

The application process is similar to that of a mortgage: you’ll be required to supply income and tax statements, the financial institution will conduct a credit check on you and any co-applicant, and they’ll likely require a professional home appraisal to determine an accurate value of the property. (In order to get your business, most banks will cover the cost of the appraisal.)

What can a HELOC be used for?

It’s a very flexible loan. Once you’ve been approved for a HELOC, you can use the money for whatever you want – home renovations, seed money to start a business, or tuition for yourself or your children. It can also be a useful tool for consolidating other high-interest debts.

Unlike a traditional loan, you don’t get all the money upfront (and, therefore, don’t start paying interest on the loan amount right away). A HELOC is more akin to a debit account that you withdraw from as needed. This makes it a very practical financing option for major home renovations where you’ll have ongoing expenses staggered over several months.

HELOC loans are also open-ended, meaning that once you qualify for a HELOC, you can access any remaining loan amount for as long as you have the mortgage. So once you’ve paid off the renovation expenses you incurred on your HELOC, that money will be available down the road if you have, say, a short-term budget shortfall.

The Catch(es)

Obviously, HELOC money doesn’t come for free. For one, there will be a relatively modest admin fee to process an application. You may also be required to pay for a home appraisal, and you’ll need to have a real estate lawyer review the loan documents.

Although you don’t start incurring interest until you withdraw funds from a HELOC, the interest rate is a variable one that’s tied to the lending institution’s prime rate. As interest rates rise – as they’re sure to eventually start doing – the cost of carrying any outstanding loan amount will increase with it.

But the real danger is when people treat HELOCs as bank accounts they can withdraw from whenever the mood strikes, using the money to fund vacations or other unnecessary purchases. If the real estate market drops and you’ve built up too much HELOC debt, you could find yourself “under water” – with a house worth less than you owe on it. This happened on a massive scale with the recent U.S. housing market crisis, with countless thousands of people simply walking away from homes they could no longer afford.