How to Borrow Using Your Home EquityBy Caitlin in Mortgage
Being a homeowner is expensive, especially when you add it on top of all the other expenses that come along with being an adult. This is why many Canadian homeowners will choose to tap into their home equity in order to get approved for the money they need to cover the cost of a large expense. Let’s take a look at what it means to use your home equity to take out a loan.
Thinking about paying off your mortgage early? Check this out first.
What is Home Equity?
As a homeowner starts to pay down their mortgage throughout the years, they begin building “home equity.” The more they pay towards their mortgage, the more home equity they gain for future use.
Your equity will also rise if and when your property increases in value with the fluctuating housing market. Many homeowners choose to use their equity to finance something important. That particular expense might be anything from a large addition to their house, paying off their existing car loan, or to put their children through school. Whatever that cost might be, they’ll use their equity to pay it down.
Find out how much it will cost to purchase a house in your province.
Do I have Home Equity?
If you’ve been paying off your mortgage for several years, then you likely have at least some home equity. As we explained above, you build equity as you pay down your mortgage. If you decided to use your home equity to take out a second mortgage, you’ll need to have your house appraised to determine how much it is worth. But, if you’re simply curious about how much equity you have or want a general idea of how much equity you have before you head to your lender, here’s how to do a quick estimate.
In order to figure out how much equity you have, you need to know the value of your home (in this case you can use the value of your home when you bought it, just remember that the real value will likely be different) and how much you still owe on your mortgage.
Home value= $376,000
80% of value ($376,000 x 0.8)= $300,800
How much you still owe on mortgage= $232,000
80% of your home’s value – amount you owe on mortgage= $68,800
In this case, you can expect to get a second for $68,800 or less.
Keep in mind that the number you’ll get from the above equation is just an estimate as you’ll only truly know the current value of your house when you get it appraised.
How Do I Gain Access to My Home Equity?
Generally speaking, homeowners use three traditional methods to access their home equity.
Home Equity Loans
What Are They and How Do They Work?
A home equity loan is a loan that uses your house as collateral. It works similar to any other type of secured loan. Your lender will let you borrow a specific amount of money, based on the value of your home. You’ll be charged interest and have fixed installment payments.
How Can I Get One?
To get a home equity loan you need to own a house, which needs to be appraised by your lender, have paid off a significant portion of your mortgage and be financially secure enough to handle taking on more debt.
How Do I Use One?
With a home equity loan, you’ll be able to borrow a maximum of 80% of property’s appraised value, minus what you have left to pay on your original mortgage. You’ll then need to pay off both mortgages at the same time.
Home equity loans are also common for those who would prefer to use a large sum of money to finance something within a short timeframe. Actually, it’s the opinion of many real estate experts that home equity loans should be paid off inside of 5 years because of the high-interest rates associated with this type of loan. Since a lender will be taking a large risk by lending what could be 80% of your property’s value and is not going to charge mortgage default insurance, their interest rate is going to be higher than a traditional HELOC.
HELOC (Home Equity Line of Credit)
What Are They and How Do They Work?
There are a few notable differences between a home equity loan and a home equity line of credit. The first difference is that a HELOC is just that, a line of revolving credit, as opposed to a loan, which is one large sum of money. Because of this, you can use that line of credit at your leisure and regain access to the full limit as you pay off the balance.
How Can I Get One?
You’ll be able to open a line of credit through your bank, or most traditional financial institutions, as well as private mortgage lenders. However, banks will typically require a high credit score in order for you to qualify. A home equity line of credit will often be a more reasonable and appealing offer to homeowners because the interest rate involved will be lower than that of a home equity loan. Potential borrowers must first have their property appraised to make sure they have enough home equity to qualify for a HELOC. These lines of credit are only granted to borrowers who have at least 20% home equity in their property.
How Do I Use One?
You are able to open a HELOC for up to 65% of your property’s appraisal value. However, if your lender combines your HELOC with the remainder of your mortgage, you’ll be able to increase the borrowing limit to 80% of the home’s appraised value at the time you closed on your mortgage. One your line of credit is secured, you can borrow from it as you wish, as long as you keep up with the minimum monthly payments.
Check out this infographic for tips on how to purchase a house in Canada.
Refinancing Your Mortgage
What is It and How Does It Work?
If you decide to refinance your home, you might end up having to pay a penalty to break your first mortgage contract. You’ll then negotiate a new contract with your lender so that you can take advantage of your home equity in the process. If you don’t want to pay the penalty fee, you can simply wait until the end of your term. Like a home equity loan or HELOC, you’ll be able to borrow up to 80% of your home equity, with the exception of what you have left to pay on your first mortgage.
How Can I Do This?
Once again, you’ll need to have your property appraised. You’ll then need to break your original mortgage contract and renegotiate for a new one through your current lender or another. Just be aware that if you decide to refinance your mortgage in order to gain access to your equity, you could be charged a prepayment penalty fee for breaking your mortgage contract. However, if your mortgage is ready for renewal or your lender’s penalty fees are not too steep, refinancing might be the most reasonable option for you.
HELOC, Refinance, or Second Mortgage? Find out choice works best for you.
Some of the Advantages of Using Your Home Equity
- You Can Use Your Equity to Strengthen Your Home’s Value – Since your home is an asset, you can use your equity to finance any renovations you might want to do, thus increasing your home’s market value, if and when you decide to sell it.
- Interest May Be Deductible On Your Tax Return – If you decide to use the extra money from your second mortgage loan for investments that will produce an income, it’s possible to use the interest for a tax deduction.
- You Can Use Your Equity For Anything You Want – While some homeowners choose to use their home equity for renovations or to finance other properties, others will use it to pay for their children’s’ or their own education, or even go on vacation. You can also use your equity to take care of any other higher interest debts you might have on your plate.
Some of the Disadvantages of Using Your Home Equity
- You Need to Pay for Various Fees Before You Can Borrow – using your home equity is certainly not a free service. There are a number of costs that you have to pay for before you are allowed access to it, such as fees for the appraisal, the application, and legal documents.
- Variable Rates = Variable Interest Costs – when it comes to variable home equity loans and lines of credit, the monthly rates will vary according to your lender’s standards and the real estate market. You might choose to borrow at a variable rate because initially, the rate might be cheaper than that of the fixed rate option. However, be aware that if you choose a variable rate your interest rate can change. So, it’s important to take this into consideration before you decide to use your home equity.
- Using Your Equity for Investment Purposes Comes With Its Own Risks – If you decide to use your home equity to make unsheltered investments, not only is it likely that you will have to pay taxes on them, but like any unsheltered investment, there’s the possibility that you could lose your money because of how the stock market fluctuates.
- Failure to Make Your Payments Can Result in Your Home Being Taken – The most significant disadvantage of borrowing your home equity comes when a homeowner is not being responsible with the credit they’ve been given. Borrowing against your home works the same ways as any other type of secured loan. You need to keep up with your payments. Defaulting on your payments can lead to your home being foreclosed. So, before taking out a second mortgage, you need to be absolutely certain you’ll be able to make regular payments.
When it comes to borrowing and your home, your credit score is important. Check out this video for everything you need to know about credit scores.
Mortgage Rules in Canada
As of October 2016, there have been several changes put in place for Canadian housing rules. The Liberal Government is trying to assure that new homebuyers are only purchasing houses that they can afford. Mortgage rates have in fact been on a steady decline in recent years, making houses in many provinces more affordable. However, the Canadian Government is concerned about what will happen should those interest rates rise in the years to come, which is more than likely. So some changes have been implemented to hopefully lessen the risk for both borrowers and lenders, such as:
- On October 17th, 2016, the Canadian Government declared that anyone interested in acquiring an insured mortgage will be subjected to a “stress test” to determine the likelihood of them being able to make their monthly payments, if and when interest rates should rise.
- In previous years, foreign buyers have been purchasing Canadian homes, refurbishing and selling them, but not paying taxes on the homes as their primary residences. Because of this, homeowners must now inform the Canada Revenue Agency about the sale of their primary residence at tax season. However, Canadians who are selling their primary residence will be exempt from a capital gains tax.
- Until 2016, the Canadian Government has assumed 100% of the risks associated with insured mortgage buyers who’ve gone into default on their payments, with no risk on the lenders themselves. The government is now planning to implement a proposal that will put a certain percentage of the risk on the shoulders of the lender.
- As of November 30, 2016, a number of general requirements have been issued for any potential homebuyers who wish to obtain government-backed insurance on low-ratio mortgages:
- An amortization period of 25 years or less is required on all insured mortgages.
- The house the homebuyer is trying to purchase must cost less than $1 million.
- The property has to be occupied by the homebuyer in question.
- The homebuyer needs to have a minimum credit score of 600.
Consider All Your Options
Remember to review and consider all your options carefully before you decide to take out a home equity loan, open a line of credit, or refinance your home in order to gain access to your equity. Each option comes with its advantages and disadvantages. So, it’s best to talk to a mortgage professional before making a serious decision about your home equity.