Home Equity Loans in Canada Best Explained

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Overview Of Home Equity Loans In Canada

Home Equity Loans in Canada allow you to convert the equity in your home into liquid cash. You can use this money to finance your home renovation, educational expenses, elective medical bills, and more.

Other mortgage programs you can use to convert the equity in your home to liquid cash are Home Equity Line Of Credit (HELOC) and Mortgage Refinance.

Our goal with this short guide to Home Equity Loans in Canada is to help understand what it is, the pros and cons, how it works, how to use it, and how to qualify for it. 

Let’s start by understanding what Home Equity is;

What Is Home Equity?

Home equity is the difference between the market value of your home and your mortgage, plus any other loans secured against the house. 

The equity in your home can increase in two ways;

  • Appreciation of your property value: Generally, when the market value of your property improves, your equity stake in the property also increases. Let’s assume that a house you bought for $350,000.00 two years ago with a $330,000.00 mortgage loan is now valued at $550,000.00. This means that the home equity value in the house increased by $200,000.00 over the two years. With a Home Equity Loan program, you can convert part of this $200,000.00 value into cash.  
  • When you pay down your home loan, as you make the regular mortgage payment, part of it pays down the mortgage loan on the house. This payment helps to reduce your mortgage loan, which in turn increases your equity value in the property—continuing with the above example of the 350,000.00 property you bought two years ago with a $330,000.00 mortgage loan. 
    • Over the past two years, you have made a total payment of $34,000.00, of which $14,000.00 was the interest cost, and $20,000.00 goes to pay down the loan. 
    • As of today, your mortgage loan balance is $310,000.00 ($330,000.00 – $20,000.00)
    • Over the two years, you have increased the equity value of your home by $20,000.00
    • In addition to your initial down payment of $20,000.00, your total equity value is $40,000.00

The good thing about your home equity is that you can use it as collateral for a low-cost term loan or line of credit. The loan can help you finance your home renovations, children’s education, or a down payment on a second home.

There are two ways you can use your home equity to borrow money 

  • Home equity loan 
  • Home equity line of credit (HELOC) 

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What Are Home Equity Loans In Canada?

Home equity loans (also called the second mortgage) allow homeowners to borrow money against the equity in their homes. 

With a home equity loan, your home equity is the collateral that secures the loan. Consequently, you may lose your home if you default on your home equity loan. In addition, if real estate values reduce, you may owe more than your home’s value. 

Since your asset guarantees the loan, you can borrow a large amount at a low interest rate. The rate on a home equity loan is usually less than that on an unsecured loan like credit cards or personal lines of credit.

Pros and Cons Of Home Equity Loans

Before taking a home equity loan, you must review all available options. Although it is an excellent source of cash, it also has some disadvantages.

Pros

  • Interest rates are lower. You won’t pay as much interest if you use your home as security.
  • There are tax advantages. If you use the loan to upgrade your home, you can remove the interest from your taxes.
  • Home equity loans provide more funds than any other source.
  • You can use the money for any purpose, from home renovations to paying a child’s tuition or vacation. 

Cons

  • Your home is at risk. If you can’t repay the loan, you can lose your home. 
  • You could be indebted more if the value of your property declines.
  • Home Equity loans or second mortgage loans tend to be priced at a higher interest rate than a first mortgage loan. The Equity loan holder takes on the second charge on your property, which has more risk compared to the position of the first mortgage holder. 
  • A home equity loan’s upfront cost can be higher, especially if your credit score is not the best. 
  • Sometimes, it is necessary to take on debt. It is a way to pay for essential items with low interest rates. But It is still debt, and you must include payment in your budget.

How Does Home Equity Work?

A mortgage is a one-time loan with the entire amount paid in one lump sum. 

You can then be required to repay the loan over a period on a fixed schedule. The repayment you make for the loan is made up of your principal and your interest payments. The principal payment pays down the borrowed loan, and the interest payment pays the loan cost. In addition, with a mortgage, If you need more funds after the first lump sum payment, you must reapply for another loan.

Home equity is the difference between what you owe on your mortgage and what your home is worth. 

For example, If you owe $400,000 on your mortgage and your home is worth $600,000, you have $200,000 in home equity.

In Canada, lenders are not required to borrow over 80% of your property’s value. Therefore, for a 600,000.00 house with an outstanding first mortgage balance of $400,000.00. The maximum home equity loan you borrow is

  • Borrowing Limit: 80% of 600,000.00 = $480,000.00
  • Available Equity: $480,000.00 – $400,000.00 = $80,000.00
  • You can borrow this $80,000.00 as a home equity loan. 

 

Your credit score, debt repayment history, and income qualification ratios will also influence the amount you borrow. 

If you wish to use your home equity to obtain a loan, you need to pay attention to the following :

  • Increase the equity on your home by making payments on your mortgage or renovating your property to increase its value
  • Consider the risks of using your home as security. Check personal loan options or other debt consolidation loan choices that need to use your house as collateral.

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Difference Between A Home Equity Loan And A HELOC

A home equity loan is a one-time loan with the entire amount paid in one lump sum. You are then required to repay the loan on a fixed schedule. 

The repayment you make for the loan is made up of your principal and your interest payments. The principal payment goes to pay down the borrowed loan, and the interest payment goes to pay the loan cost. 

In addition, with a home equity loan, you must reapply for another loan if you need more funds after the first lump sum payment.

On the other hand, with HELOC, the entire amount (the credit limit) is not paid to you upfront but retained as a credit line, from which you can withdraw, spend and repay as needed. 

HELOC allows you to continue to borrow for the entire loan withdrawal period without reapplying. You must only pay the minimum interest payment for a home equity loan.

Is A Home Equity Loan A Good Idea?

A home equity loan is good if you use the funds to improve your home or consolidate your high-interest debts. However, it is not a good idea if the home equity loan causes you to overstrain your finances or move debts around. 

If you know precisely how much cash you need to borrow with a clear goal to put it to use to either increase the property value or reduce your debt burden, then a home equity loan may be a good idea.  

Home equity is more cost-effective for financing substantial expenses than credit cards or personal loans with high-interest rates.

How To Qualify For A Home Equity Loan

You need to meet some criteria before you can qualify for a home equity loan:

  • At least 20% equity in your home 
  • Prime mortgage lenders usually need a minimum credit score above 650. In some cases, those with a credit score less than 620 can qualify for a home equity loan if they have more equity on the property and a low debt-to-income ratio. Such loans usually have higher interest rates, lesser loan amounts, and shorter terms. 
  • You can still get a home equity loan with a low credit score of less than 620, but it may come at a higher interest rate and upfront costs. Alternative mortgage lenders offer low-credit home equity loans. 
  • A Debt-to-income ratio of 44% or less.
  • An 80% combined loan-to-value (CLTV) ratio. This is the ratio of all secured loans on the property to the appraised value of the property.
  • A reliable source of income
  • Excellent payment history 

Other Considerations

Although applying for a home equity loan in Canada may be a good financial decision, it is not the best choice for everyone. 

If you are uncomfortable with using your house to secure debt, you should explore other alternatives. 

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