HELOC: How a Home Equity Line of Credit Works

A home equity line of credit (HELOC) is a form of credit that uses your home equity as collateral.

A HELOC can help you make major purchases or consolidate debt, often at a lower interest rate than you’d pay using a credit card or personal loan.

Falling behind on HELOC payments could result in losing your home, so have a sound repayment plan before using this type of loan.

What is a HELOC?

A HELOC loan is a secured, revolving form of credit.

“Secured” means that the loan is backed by your home; if you miss payments, your lender can take possession of your home.

“Revolving credit” means that you can borrow up to the limit, but you don’t need to tap it all at once. For instance, you could borrow a fraction of the limit to renovate a bathroom, and, the next year, you could borrow an additional amount to buy a boat. Credit cards are another example of revolving credit.

Pros and cons of a home equity line of credit

HELOCs vs. home equity loans

A HELOC and a home equity loan are similar in that they both use home equity as collateral. But they have some key differences:

How a HELOC works

Like most credit products, you’ll have to apply for a home equity line of credit.

To qualify, you’ll need equity in your home. Most lenders want you to have at least 20%. You’ll also need to provide:

You’ll also be required to pass the same stress test lenders use when reviewing primary mortgage applications.

How big of a loan can you get?

If your HELOC is combined with a mortgage, you can access a maximum of 65% of the property’s market value. But your outstanding mortgage balance combined with your HELOC can’t exceed 80% of the value of your home.

HELOC rates and fees

HELOC interest rates often consist of a lender’s prime rate plus a fixed percentage. For example, if your HELOC interest rate is prime + 2%, and your lender’s prime rate is 6%, the rate on your HELOC would be 8%.

Compared to credit card rates, which can be 19.99% or more, HELOCs tend to have favorable rates.

HELOC rates are typically variable, which means they fluctuate based on the Bank of Canada’s overnight rate. Whenever the overnight rate increases or decreases, lenders’ prime rates move the same amount in the same direction.

In some circumstances, you can negotiate a lower HELOC rate. In addition to demonstrating a strong, stable financial picture, you can share HELOC rate quotes you’ve received from other lenders. It’s also a good idea to check with lenders or financial institutions you already have a relationship with — they may be more flexible to retain your business.

When getting a HELOC, you can expect to pay the following:

These fees can add up to thousands of dollars and are one of the reasons that arranging a HELOC is often more complicated and expensive than setting up an unsecured line of credit.

Types of HELOCs

Home equity line of credit combined with a mortgage

A home equity line of credit combined with a mortgage is the most common type of HELOC. Most Canadian lenders offer this type of HELOC.

The mortgage portion is a standard home loan; you’ll make regular payments that go toward both the principal and interest. The HELOC portion doesn’t typically have a fixed payment schedule, and minimum payments are based only on interest (although you’ll also need to pay off the principal, otherwise interest will continue to accrue).

As you pay off your mortgage, your equity increases. As a result, your lender can also increase the amount you can borrow with your HELOC. However, the value of a home is never guaranteed, and if the value of your home drops, your lender can reduce your line of credit.

Stand-alone home equity line of credit

A stand-alone home equity line of credit doesn’t include a mortgage. It’s simply a revolving line of credit guaranteed by your home. Since this HELOC is not tied to your mortgage, your borrowing limit won’t automatically rise as you pay down your mortgage principal.

Your borrowing limit is based on the amount of home equity you have when you apply for the HELOC, though lenders can adjust it in the future as your equity and your home’s value change.

Getting and paying off a HELOC

With a HELOC, you’re not borrowing a single lump sum upfront. Instead, you’re opening a revolving line of credit that you can tap into as you choose. How much you use and when you decide to access it is up to you.

When paying back your HELOC funds, you’re required to make minimum monthly payments, which are interest-only. But, like paying only the minimum amount on credit card debt, paying only the interest on a HELOC is costly in the long run. Any unpaid principal will continue to rack up interest charges until it’s paid in full. You can pay off the principal in a single lump-sum or over time like you do with your mortgage.

A HELOC can provide access to much-needed funds, but it’s best to have a plan to repay the entire amount before applying for one. Only borrow what you need to, and try to repay more than the minimum interest payments.

Alternatively, you could ask for a lower limit when applying, so you’re not tempted to spend more than you should. Regardless of how you approach a HELOC, ensure that you understand the terms and conditions and are confident you can pay back your loan.