While both are loans associated with home ownership, home equity lines of credit and mortgages are distinct in ways that potential borrowers need to fully understand.
To help you decide which option is best for you in specific scenarios, here are key differences to know when considering a home equity line of credit vs. a mortgage.
How a home equity line of credit works
A home equity line of credit, or HELOC, is a revolving line of credit that allows you to borrow against the equity you’ve accrued in your home.
Home equity is the difference between your home’s market value and how much you still owe on your mortgage. In Canada, you can borrow up to 65% of your home’s value through a HELOC. (You can actually borrow up to 80% of your home’s value, but only 65% can be a HELOC and the rest would have to be a fixed-term mortgage.)
A HELOC works a bit like a credit card in that you have a pre-approved limit, can borrow at your own pace, and repay the outstanding balance as you go.
Like a credit card, a HELOC tends to have a variable interest rate, which is often the bank’s prime rate plus an additional 0.5% to 2%. If the prime rate goes up, your HELOC’s rate will also rise. You’ll only pay interest on the HELOC funds you actually use.
A HELOC is considered revolving credit because you can keep borrowing from it over time, as long as you haven’t reached your credit limit and continue to make your minimum payments.
How a mortgage works
A mortgage is a loan specifically designed to purchase, build on or refinance of a piece of real estate. Unlike the funds from a HELOC that you can use as you see fit, mortgages are intended to cover most of a property’s price. As such, mortgages are often for a much larger amount than a HELOC, which is limited by an existing home’s value.
A mortgage’s repayment terms are typically far less flexible than those of a HELOC. Your payments will be put towards both the interest and principal, and you’re expected to repay your mortgage over a long period, often 25 years or more.
Mortgage repayment happens on a strictly defined schedule that’s decided by your lender, and there may be steep penalties for early repayment, depending on the type of mortgage.
Mortgage interest rates may be variable, like a HELOC, but you also have the option of choosing a fixed mortgage, where the rate is locked for a set term.
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Home equity line of credit vs. mortgage: How to choose
In the debate of HELOC vs mortgage, it’s important to understand what kind of financial product works best for your needs. Here are some things to consider:
What are your financial goals? If you want to buy a new home, you’ll likely need a mortgage — unless you already own a home or have a lot of money saved up. However, if you already have a home and want to take advantage of your equity to finance a major renovation or pay down high-interest credit card debt, a HELOC is likely the better choice.
Are you financially disciplined? Because it offers easy-to-access cash with flexible repayment terms, a HELOC can lead to significant debt if you find it hard to control your spending. In fact, the Financial Consumer Agency of Canada states that “HELOCs are the largest contributor to non-mortgage consumer debt, more than double that of either credit cards or auto loans.” Other financing options, such as a bank loan or line of credit, may be a better bet if overspending is a risk.
What’s the financial forecast? Variable rate loan products like HELOCs are affected when interest rates rise. This means that the cost of borrowing via a HELOC can increase over time. If that’s not a risk you’re willing to take, you may want to choose a mortgage or other fixed-rate loan product that offers consistent payments over a set repayment term.
HELOC vs. mortgage pros and cons
Pros of HELOC
- Pay interest only on the amount you withdraw.
- Borrow what you need and pay off the entire balance when you want to.
- No prepayment penalty.
Cons of HELOC
- Could lead to debt and overspending.
- Interest rates could rise.
Pros of a Mortgage
- Choice of a fixed or variable interest rate.
- Predictable payment schedule.
- Predictable payment amounts, if you choose a fixed-rate mortgage.
Cons of a Mortgage
- Locked into a mortgage contract.
- Non-flexible payment schedule.
- Could be penalized for early repayment.
Mortgage alternatives to a HELOC
A HELOC is one type of second mortgage. Another is a home equity loan. As the name implies, a second mortgage is a loan you take out on top of an existing mortgage. Unlike a HELOC, you can get a home equity loan for up to 80% of your home’s value.
Like a regular mortgage, home equity loan funds are paid as a one-time, lump-sum. Borrowers are required to make payments (that cover both interest and principal) on a set schedule. One of the main downsides of a home equity loan is that they tend to have higher interest rates than first mortgages or HELOCs.
If you’re over the age of 55, a reverse mortgage allows you to take out 55% of your primary home’s value. You can use the money for anything you want, including home repairs, debt repayment or medical expenses. You’ll only need to pay it back when you sell the property, or your estate will repay it after you die.