Home equity can be useful to cover one-time costs while arranging the tax-efficient sale of investments or withdrawals from registered or corporate accounts.Fred Lum/the Globe and Mail
Home equity lines of credit (HELOCs) can be a flexible way for homeowners to access borrowed funds, withdrawing money as needed from a variable-rate lending account secured by the value of their home.
However, the calculus around HELOCs may have changed as housing prices sag in some markets and speculation swirls about interest rates rising to counter inflation.
Mark Lotocky, an advice-only financial planner and owner of the Dixon Davis Group in Victoria, had a client whose child bought their first home but soon realized the foundation was crumbling; then their car died. The parent helped pay for the renovation, but another big lump sum was needed for a new car.
To avoid selling investments and incurring taxes, the parent borrowed from their HELOC, and the child will repay the loan at the low, secured HELOC interest rate.
“There should be emergency funds … but sometimes [the need] goes beyond the emergency fund,” Mr. Lotocky says. “If you have a HELOC, you might be able to access [funds] for prime plus 1 per cent or prime plus 2 per cent, which is going to be a lot cheaper even over time than to [make taxable withdrawals] from an RRSP.”
One challenge is that the prime rate (4.45 per cent) is now significantly higher than it was five years ago (2.45 per cent). At the same time, the outlook for investment markets has weakened.
In this environment, Mr. Lotocky says selling non-registered investments to cover a large expense may make more sense than borrowing – although it depends on the situation.
Risks from interest rates and declining home values
Interest rate fluctuations are the most obvious risk associated with HELOCs, as higher interest rates immediately translate into higher interest-only payments. That can cause a shock to cash flow, says Kate Murdoch, wealth advisor, investment advisor and portfolio manager with Holmes Murdoch Wealth Management at Richardson Wealth Ltd. in Victoria.
That’s one reason she sees HELOCs as a borrowing solution for defined, short-term liquidity needs. Home equity can be very useful to cover small or large one-time costs while someone is arranging the tax-efficient sale of investments or withdrawals from registered or corporate accounts.
However, borrowers may be tempted by the quick and convenient access to credit. Without a repayment strategy that’s integrated into a financial plan, HELOC debt “can very easily become permanent debt,” Ms. Murdoch says.
Furthermore, those who max out a HELOC by borrowing close to the available credit limit are vulnerable to unfavourable real estate markets. That’s because the limit is set based on a percentage of the home’s value. If the value drops, so does borrowing capacity.
“Lenders tend to look at freezing future borrowing or restructuring the debt to a payment schedule before calling any of the credit or asking the borrower to make a repayment,” Ms. Murdoch says.
Still, “it’s extremely important to limit use [of a HELOC] to comfortable levels so that when risk factors inevitably change, the user is not caught offside,” she adds.
Apply before retiring
People contemplating retirement may want to apply for a HELOC before they stop working full-time.
“Approval tends to be more straightforward while [they’re] still working and have consistent cash flow from employment, [and] it allows them to have this line of credit as an avenue for liquidity – emergency funds that might be harder to qualify for later,” Ms. Murdoch says.
One use for a HELOC in retirement, she adds, might be to help people age in place – essentially, allowing retirees to leverage equity in their home to pay for accessibility modifications and home care.
In some situations, that may be preferable to making aggressive, taxable withdrawals from a registered retirement income fund. Again, interest rate and housing market risks must be factored in.
Having a strategy for credit is key
Whenever someone is considering opening a HELOC, credit advice is essential, says Nick Palucci, vice-president of home equity finance with Royal Bank of Canada.
HELOCs aren’t necessarily the best option, with some clients benefiting more from a mortgage with a disciplined repayment schedule, for example, or an unsecured term loan with a fixed interest rate.
Regular check-ins are also critical, because interest rates, housing markets and the borrower’s personal situation may all change over time. The most cost-effective borrowing vehicle today may not be the best choice in a year or two, he says.
“It’s really key to talk to an advisor, articulate what it is you want to use those funds for, get set up with the right product at that time – which could be a combination of different [solutions] – and check in at least once a year … to ensure you’re always in the right product.”