There seems to be a lot of confusion out there among current homeowners over their Home Equity Line of Credit (HELOC) options: what exactly are they and when should they be used? While you may be familiar with the idea of tapping into your home’s equity in a pinch, the truth is that a HELOC can be useful for more than just an emergency fund. In fact, it can be a pretty effective tool when used to rearrange your debt and create new savings.
A New Year, and a New You
If your mandate for the new year is to become more financially savvy, there are a few tools at your fingertips for saving (and making!) more money. For starters, you could try out a different investment vehicle, switch to a credit card better suited to your needs (check out our Best of Finance winners list for some inspiration), or you can take a look at your current assets and credit products in a whole new way.
Let’s say your home is worth $700,000, and you have $350,000 remaining on your five-year fixed mortgage at 3.50 per cent. Let’s say the mortgage had an original amortization of 25 years, and you’re three years into your five-year term. We’ll assume you drive a luxury vehicle worth $65,000 with a $30,000 loan, which can be paid out without penalty at any time. You also carry a few credit cards but you consistently pay them off on a monthly basis. To pay your mortgage and loan down, you make affordable bi-weekly payments that work out to be $1,215.
You may think you’re sitting pretty – but could you take your financial situation to the next level? This is where your home’s equity comes in handy.
How to Access Your Home’s Equity
Since you have a 50 per cent Loan to Value (LTV) in your home, there are a few options available to you; namely refinancing your current mortgage or adding a second mortgage or HELOC.
Of course, there are pros and cons to consider with each option. For example, with refinancing, you could be facing penalties associated with breaking your current mortgage and you may have to absorb legal fees in order to assign a larger mortgage value. If you’re considering a HELOC in second position, it’s vital that the lender is willing to be placed behind the first priority mortgage as well – and don’t forget the legal fees to assign the HELOC.
The good news is that not all lenders will charge you for legals and there’s always the possibility of working penalties into your refinance through a ‘blend and extend’ technique – leave it to your mortgage professional to work out the details! One important note: as of last June, HELOC LTVs are capped at 65 per cent for federally regulated financial institutions. If you’ve surpassed this benchmark already, refinancing is your only option.
So which option presents the bigger payoff? Let’s break down the numbers:
Refinancing Face Off
- Requires taking out a $385,000 mortgage to pay off your existing one, car loan, and cover an estimated $5,000 in legal and penalty fees.
- Assuming you lock back into a 2.89 per cent 5-year fixed with the same 22-year (remaining) amortization.
- Pros: One debt payment each month instead of two and a guaranteed lower interest rate for five years.
- Cons: Legal and penalty fees
The breakdown: Your new bi-weekly payment is $909, which is $306 less than your regular bi-weekly payment, even after factoring in the legal fees and penalties! Let’s then say you decide to sweeten the pot and save more; after all you are comfortable with your current debt payments. Once you jack up your bi-weekly payments back up to $1,215 – you knock off seven years of mortgage payments!
The verdict: Your old situation left you with a mortgage for 25 years, your new situation has you paying your mortgage for 18.
Would You Like a HELOC With That?
- Add the $30,000 HELOC for a $600 legal fee in second position and pay off your car loan.
- Assume the HELOC is at Prime + 0.50% (effective 3.5 per cent).
- Pros: Cheaper legal fee because you are not discharging and re-assigning, only adding a separate charge in second position.
- This is a revolving credit product so the available balance is always at your finger tips for future use.
- You can pay this off at ANY time without penalty if it is revolving and not locked in.
- Cons: Your effective interest rate between your current mortgage and your new HELOC is still higher than that of the refinancing option.
- You’re with a variable rate that is dependent on prime (although, prime has held pretty steady in this market)
- You’ll still be making two payments each month.
- Paying interest only can push you farther into debt (this is a common feature on HELOC products).
The Verdict: If you continued to pay $700/month (this was your car payment) to your HELOC, you would have it paid off in under four years. At that point in time, your mortgage balance will be around $308,000 with 18 years remaining. If you make annual lump sum payments of $8,520 each year ($700 x 12), you will pay off your entire mortgage and HELOC in a total of 16 years.
So which option comes out on top? Well, should rates not change whatsoever over the next 20 years, it’s safe to say HELOCs are winning the race. However, as it’s VERY unlikely that you will be able to renew into the same fixed mortgage rate for the entirety of your amortization, and it’s just as unlikely that prime will not change. Always speak with a mortgage professional when weighing your options and creating your own interest rate projections.
RateSupermarket.ca Week in Review
A very boring way to close out the month of January … no changes. Not one. Check in with our Mortgage Rate Outlook Panel for their February rate predictions!