As interest rates continue their upward climb -- and are set to do so for the foreseeable future -- much of the focus has been on mortgage borrowers, and how a steeper borrowing environment will impact their affordability. But other types of floating-rate debt are as equally exposed to the Bank of Canada’s hiking whims: namely Home Equity Lines of Credit (HELOC).
Secured by the equity of one’s home, HELOCs are a popular borrowing product lauded for their ease and flexibility; borrowers can generally tap up to a maximum of 80% of their home’s value. Like a traditional mortgage, applicants must have good credit standing, show proof of income, and be stress tested to be granted the funds. However, the biggest difference between the two products is that HELOC debt isn’t amortized over time -- it revolves, just like a credit card balance. Minimum payments are interest-only, with the principal never needing to be repaid as long as the borrower owns their home.
With interest rates only marginally higher than that of a mortgage (today’s typical HELOC rate is Prime + 0.5% -- 3.7% -- compared to a five-year variable mortgage at Prime - 0.5%), they’re one of the cheapest ways to access cash in a hurry. And as consumers have been squeezed by the triple vice of rising interest rates, high cost of housing, and soaring inflation, it would appear they’re increasingly turning to HELOCs as an option. Office of the Superintendent of Financial Institutions (OSFI) data shows that while HELOC balances had been drifting lower in recent years, they abruptly jumped by 1% in February; that’s the biggest monthly increase seen in a decade, according to Edge Analytics.
And just as a credit card balance can easily spiral out of control, so too can a HELOC balance, especially as minimum payments will assuredly rise this year and next.
“You could drive a car off a cliff or you could blow your brains out with a HELOC. Anything you misuse has risks. That doesn't detract from their utility,” Robert McLister, Mortgage Strategist at MortgageLogic.news, tells STOREYS.
“HELOCs are invaluable in the right hands. They're a cheap instant source of liquidity for investments, business use, home improvements and emergencies, among many other things. For some, HELOCs make a great alternative to an emergency fund. Instead of letting your rainy day fund rot in a 2% savings product, you can invest those funds longer term, earn higher returns and only tap your HELOC in emergencies.”
He foresees that, given the bond market is pricing in another 2% in BoC hikes, HELOC rates will be in the neighbourhood of 5.7% next year, resulting in interest-only payments rising from $306 per month to $469, per $100,000 borrowed.
Mclister is also seeing some emerging trends in HELOC use as incomes are not keeping pace with the cost of living. Not only are people forced to borrow to stay afloat, but these loans are increasingly funding the “bank of mom and dad” as homeowners, rather than taking out a reverse mortgage, are instead pulling out equity for the purpose of down payment gifts.
It’s All About Risk Appetite
James Laird, COO of Ratehub.ca, says those getting a HELOC should have the same risk appetite as those getting a variable-rate mortgage (there is no such thing as a fixed-rate HELOC.)
"In terms of the risk factor, you know you’re paying more for that product because of the flexibility. You’ve made the decision that instead of getting Prime minus one, [you're] getting Prime plus a half because you value the flexibility,” he says. “But then you have rising rate risk -- it’s the same risk with a variable rate mortgage in that you don’t know what your interest rate is going to be next year, or next month.”
Laird adds that HELOCs are best used for temporary, smaller balances, or for larger sums when the borrower has a clear idea of how, and when, the funds will be paid back.
“Maybe you have an inheritance coming, or a second property that you use a HELOC to fund, but your house is selling in two months; that’s the perfect use for a HELOC,” he says. However, it “never makes sense” for borrowers to keep the revolving balance owing over the long-term. In this instance, Laird says, they’re best advised to refinance their loan into a traditional mortgage product.
Have a Payback Plan in Place
The bottom line is, if you are considering taking out a new HELOC in today’s rising interest rate environment, you’re wise to do some forward-looking calculations, says personal finance expert and journalist Rubina Ahmed-Haq.
“If you are borrowing money out of your HELOC, you should do the math of what rates could be in the future,” she tells STOREYS. “Let’s say you’re borrowing right now at 3.2%, minus 0.5 -- if you’re borrowing at that, could you still afford to pay if you were borrowing at 3.5%, 4%?”
As for those who may be currently carrying a balance, they should “absolutely” be in debt repayment mode, she says.
“The one thing that gets people the most during tough economic times or a recession, is their debt obligations. If they have money they’ve borrowed from different sources -- an auto loan, money they’ve taken out of the home, they’ve got a mortgage, maybe they’ve got a student loan lingering -- not all loan products are affected, but the ones that get more expensive, it just collectively raises your cost of borrowing.
“We’ve seen survey after survey that finds many people in Canada just can’t afford to increase their lifestyle by $200 or $300 dollars. The problem is when you get to that very, very edge, then you have to make tough decisions: ‘Do we sell this house and move somewhere more affordable? Do I take on more hours at work?' Things that require some real grit; it’s not just about cutting back on spending, it’s not as simple at that point.”
HELOCs Still Considered “Safe” Option for Lenders
The recent growth in HELOC use and balance size has caught the attention of Canada’s banking regulator; OSFI has recommended banks review “the authorized amount of a HELOC where any material decline in the value of the underlying property has occurred and/or the borrower’s financial condition has changed materially” in attempts to increase monitoring of borrower's credit quality.
McLister points out that borrowers finding themselves in hot water with their HELOCs will swiftly feel the consequences.
“Once you hit 85-90% credit utilization, if you stop making principal payments and you exhibit other risk factors (like a plunging credit score and falling property value) lenders take notice,” he says, adding that lenders may even freeze HELOC funds if they feel a borrowers’ risk profile has deteriorated.
However, he adds, the average HELOC balance is comparatively small, at $75,000, and Canadian borrowers generally have a good track record with them; arrears are smaller than they are for mortgages, and “drastically" lower than for credit cards.
“HELOCs remain a conservatively underwritten safe product for lenders,” he says. “Regulators also worry that HELOCs lead to persistent debt. That's true. But if it's good debt (i.e., prudently managed debt that generates income) this is minimally relevant from a personal risk standpoint.”