The Power of HELOC
So you own a home and would like to buy an investment property, but all of your savings have been locked up in your home? The answer to your problem is a Home Equity Line of Credit or HELOC.
HELOC (also known as “Secured Line of Credit”, “All in One”, “STEP”, etc.) is a line of credit that is secured by your home. The bank registers a charge against your home, in exchange for your ability to borrow money from the product, at rates significantly lower than an unsecured credit would offer.
Rates offered within HELOC are tied to the Prime rate and are currently offered at Prime (3.95%) + 0.5%, i.e. 4.45%. Unsecured lines of credits typically offer rates that are between 8% and 10%, rarely lower than that.
The beauty of the HELOC is that, once approved, you can use it towards anything – as a down payment on an investment property; to renovate your kitchen or basement; to help your children with the purchase of their home; to buy that condo in Florida or back in the old country – the choice is yours.
HELOC can be registered as a 1st or a 2nd mortgage.
Let’s assume your home is worth $500K. You already have a mortgage of $300K with a good rate, so you don’t want to break your mortgage but need access to equity. Since the maximum that you can borrow is 80% of property’s value (in this case, $400K), and since you already owe $300K on your mortgage, you would be eligible for a HELOC of $100K.
In this case a $100K HELOC would be registered as a 2nd mortgage, completely unlinked to your 1st mortgage. You will pay a minimum payment of interest-only on the amount you owe and your limit will not change, irrelevant of what happens to your 1st mortgage. Your line would be fully open, meaning that you can pay it off in full at any time, without penalty.
However, the full potential of the HELOC is unlocked when registered as a 1st mortgage. You can have multiple products inside of it, such as mortgages, lines of credit and credit cards. You can lock-in line of credit balances into mortgages and lower the borrowing rates. You can split products between those used for personal use versus those for investment.
Let me illustrate the power of a HELOC through an example. Let’s assume your property is worth $500K and your mortgage of $300K is coming up for maturity. You are really torn on whether to go with a fixed or variable rate. You will also need money for the down payment towards an investment property in the near future. On top of that, tight mortgage rules may be an issue when qualifying for that investment property. Let’s analyze them, one by one.
The first thing to do is register a HELOC of $400K, based on the maximum 80% loan-to-value. You want to take the maximum that you’re allowed since you don’t pay for it unless you use it. Next, if you’re not sure whether to go fixed or variable, you have the option of splitting your $300K into two separate mortgages – one fixed and the other variable, and in such way get the best of both worlds.
At this point, it is very important to take the longest amortization available on your existing mortgage. That will allow you to lower your payments and maximize your purchasing power for future investments. I am not suggesting that you pay your mortgage over 30 years… I am simply advising you to use “lump-sum” pre-payment options to pay your mortgage faster while improving your purchasing power via lower payments.
Once this was done, you will have a $300K mortgage inside of a $400K limit. As your mortgage goes down, your line of credit opens up. For example, when your balance drops to $280K, your line of credit limit will increase to $120K.
A few months later you decide to buy an investment property and need access to $100K. You already have $120K available. You simply write a cheque for the down payment and have your mortgage broker arrange a mortgage against the new investment property.
Once the mortgage closes, you will have the option of keeping your $100K in a line of credit at 4.45% or locking it in a mortgage inside of the same product at 3% (based on today’s rates). You could end up with 3 mortgages inside of your HELOC and another $20K available to you in a line of credit. As your mortgage balance decreases, your line of credit limit will increase, giving you access to more equity.
In Canada, if you borrow to invest, you can write off the interest on the borrowed amount. That’s why it’s important to keep the mortgages used to invest separate from those for personal use. In this example we’ve achieved exactly that – your original two mortgages are separate from your $100K investment mortgage. When you get your statements from the bank, you will know which interest you can write off and which you cannot.
The HELOC is definitely the most sophisticated product on the market. It allows you to access equity in your home when you want it, how you wanted, at the lowest possible rates on the market. If you don’t already have it, but your circumstances allow you, you should really consider it.