If you’ve been using the word ‘equity’ without knowing what it means, we’ll help you out: when referring to property, equity is the value of the property minus your mortgage. Say you buy a $400,000 home one day that’s magically worth $450,000 the next day. Bam! You’d have $50,000 in equity.
Most homeowners use their home equity for a variety of reasons, such as renovating, investing in another property, paying down debts, or even taking that much-needed vacation. In order to facilitate this, the mortgage industry has introduced an influx of flexible mortgage products. The product you choose depends on your reasons for acquiring the extra cash and the amount of equity that you’ve built in your home.
As with anything mortgage-related, you should read the fine print, especially if you decide to take advantage of one of these products in the middle of your mortgage term. There is no right or wrong way, and whatever approach you choose will depend on your particular situation, what you qualify for and any costs associated with the process compared to the benefits. Here are the most common ways to access the equity in your home.
Home Equity Line of Credit (HELOC)
A HELOC is a line of credit that is secured against your property, and it’s attractive if you don’t need all of the money at once. It can be set up as a mortgage, but it’s usually in a second position after an existing mortgage. You can get a HELOC for 65 per cent of your property’s value, although the limit stretches to 80 per cent if you combine with an amortizing mortgage. In order to get a HELOC you have to have at least 20 per cent equity in your home and as you get more equity, you can ask for the line of credit to be increased, although that requires a new application and qualification process.
HELOCs usually consist of a revolving line of credit that works like any other credit: you receive statements and make monthly payments and as the fixed mortgage is paid down, the available revolving limit increases. Because the line of credit is secured to your home, the interest payment is significantly lower than an unsecured line of credit, but that rate is usually tied to the prime lending rate and can rise if variable rates increase. In order to avoid that uncertainty, many lenders offer the option of locking in portions of their HELOC interest rate.
Since HELOCs are interest-only loans for a certain period of time, your minimum payment is going to be the amount of interest due each month on how much money you’ve borrowed. If your loan still exists after that period of time, often 10 years, then your payments will increase to include the principal. Writing off the interest is one of the reasons that homeowners are using a HELOC for investment strategies such as the Smith Manoeuvre
and other tax deductible mortgage plans
Paula Roberts, a mortgage agent with Dominion Lending Centres, The Roberts Group, believes that there is nothing else on the market that can cater to her clients’ financial needs while simultaneously offering them flexibility and low-interest, easily-accessible credit for life’s unexpected occurrences.
“The client doesn’t always know they need it now,” she says. “But down the road – when the kids are going to college, or their house needs some renovations – it could save them a lot of trouble in refinancing. If they don’t use it, on the other hand, it doesn’t cost them anything.”
Some lenders will allow you to add a HELOC to your existing first mortgage at any time, even if it’s from another lender. There are also products such as Home Trust’s Equityline Visa HELOC product (a Visa Gold card with chequeing privileges that’s tied to your home’s equity).
The lender will require an appraisal and the amount of funds they lend you will be dependent on value of the property, just as it would be with a first mortgage. Although you do have to pay for an appraisal fee and legal fees, they’re one-time charges. You also won’t have to pay any renewal fees for the life of HELOC.
An important note about HELOCs, though: the interest rate tends to be tied to the prime lending rate, but there’s nothing that says it has to be. The lender can jack up the rate or even decide to make you repay the balance of your loan in full. The likelihood of that happening is incredibly slim, but know that it is an option that lenders have should they choose to exercise it.
Home Equity Loan/Second Mortgage
A home equity loan is often confused with a HELOC, but they’re different products. With a home equity loan, you receive the funds in a lump sum as opposed to taking money as you need it. Unlike a HELOC, the interest rate and monthly payments are fixed, so you can budget accordingly.
A home equity loan is also known as a second mortgage. Technically, both a HELOC and a home equity loan are second mortgages, since they’re additional loans against your home behind your first mortgage, but a HELOC is treated more like a line of credit. Second mortgages have typically been marketed to borrowers who can’t qualify for better options, but they’re increasingly an option for people who need the money for a one-time large expense and know exactly how much is needed.
“Theoretically, the idea to get a second [mortgage] would be a short-term solution until the first mortgage matures and you could put the two together,” said Mel Gilbert, a mortgage agent with Mortgage Intelligence.
With a second mortgage you can borrow up to 80 per cent of the appraised value of your home minus the balance of your first mortgage. You make payments on both mortgages at the same time, but if you default on your mortgage, your home would be sold and the first mortgage would be paid with the proceeds along with any associated late fees and penalties before the second mortgage. Because second mortgages carry a higher risk to lenders, these products often come with a higher interest rate. The lower the amount of equity in the property, the higher the interest rate.
Don Bayer, president of MonsterMortgage.ca, says that you should only take on a second mortgage if you are certain you can pay it off in a reasonably short period of time, like two or three years.
If you have exceptional credit, you might be able to acquire a second mortgage through a bank, but if the combined values of your first and second mortgages exceed 80 per cent of your property value, you will have to pay mortgage default insurance on top of the high interest rates. In this case, it might make more sense to go through a private lender, where mortgage default insurance isn’t required. Although the private lender will likely charge a higher interest rate still, it might amount to less in the long run.
In the end, Bayer recommends second mortgages to a small handful of clients. “I only recommend them to people who don’t qualify at the banks. There are very few cases where a client should take a second mortgage at 12 to 13 per cent.”
Gilbert agrees, advising his clients to “be careful – there are a lot of sharks in the water. It’s like climbing a ladder: You try and qualify someone for the best option, and if that doesn’t work then you go to the second best and then the third best and then the fourth best, and the higher up the ladder you go, the higher the fees are and the higher the interest rates are – usually because they ask fewer questions, and all they’re interested in is if you’ve got the equity. If things turn ugly then they can get their money out.”
Refinancing requires you to break your current mortgage contract. When refinancing, you can take out the equity in your home and add it onto your current loan balance, and if interest rates are lower than they were when you got your mortgage, you can take advantage of that as well. When refinancing, you also have the ability to consolidate any other unsecured debts shop around for better terms. Essentially, you can get a new mortgage and take out the equity on your home while you’re at it.
You can borrow up to 80 per cent of the appraised value of your home, minus the amount left to pay on your first mortgage. If your mortgage is up for renewal or there are minimal or no fees associated with breaking your particular mortgage, a refinance is a good option to consider. If you don’t have that flexibility, however, then refinancing while in the middle of your mortgage term can result in big penalties.
In order to refinance, you must have at least 20 per cent equity in your home. It is popular with homeowners who have high-interest debt – such as credit card debt – and have calculated that it will save them money in interest charges if they combine it with their mortgage and pay it all off at a much lower rate. This move does have its advantages, but there are risks involved.
“One risk is that you’re reducing the equity in your home,” says Koziej. “But if you need the funds – for whatever purpose – tapping into your home equity may be the cheapest way.”
This strategy also doesn’t work if your first mortgage is at an exceptionally low rate in comparison to the current rate. In this case, it will likely save you more money if you acquire a second mortgage that matures at the same time as your first, at which point you can refinance with no extra costs.
Some lenders will allow you to blend interest rates when refinancing. If you want to take advantage of lower interest rates but don’t want to pay the penalties associated with breaking your mortgage, then some lenders will allow you to blend the new interest rate with your current interest rate.
Let’s say you a have a property that is worth $500,000 with a first mortgage in the amount of $300,000 at a rate of 2.99 per cent, maturing two years from now. Your property has increased in value since you purchased it, and you would like to access some of this equity to buy another property. If you qualify based on the lender’s guidelines, the lender will give you 80 per cent of the appraised value in funds, which in this case equates to $400,000. Since you currently have a first mortgage of $300,000 with the lender, this means that you now have access to an additional $100,000.
Assume that the lender’s mortgage rates today are 2.79 per cent for the three-year fixed and 2.89 per cent on the five-year fixed. The lender can set up a separate first mortgage for $100,000 at the rate and terms you choose. If you choose the three-year rate, your effective blended interest rate on the total funds can be calculated as follows:
($300,000 x 2.99% + $100,000 x 2.79%) / $400,000 = 2.94%
Variations of this are the “blend and extend” or “blend to term” strategies. The former is where you blend your current mortgage rate with your new mortgage rates and start a new mortgage term, and the latter is where you blend your current mortgage rate with your new mortgage rate until the end of your current term.
As you’ve seen, the maximum equity takeout with traditional lenders (including banks, credit unions and trust companies) can be done through a refinance up to 80 per cent of the appraised value of your property. Any equity take out above the 80 per cent can be accomplished through private funding
. You may be able to take out 90 per cent through private funding, depending on your personal situation and the location and/or condition of the property.
Refinancing your mortgage or obtaining a HELOC before the end of your existing mortgage term can end up costing you – and not only in higher interest rates. If you opt to go with a new lender or choose not to blend your interest rates, the costs can add up:
|Type of fee
||Three months’ interest to thousands of dollars depending on whether it’s a variable rate or an interest rate differential
||Dependent upon the insurer and loan amount
Your mortgage broker
will be able to walk you through any questions that you may have about accessing the equity in your home, help you through the calculations, and discussing the pros and cons of various strategies based on your financial outlook and future plans.
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