What is a Home Equity Loan?
As the name might suggest, a home equity loan is a loan provided by a financial institution that is secured by a borrower’s existing property. Equity is defined as the difference between the home’s current valuation on the market and the remaining balance on all mortgages. Essentially, as the mortgage gets paid down, the homebuyer builds equity in their home and can then use that equity to obtain a home equity loan.
It might be helpful to illustrate with an example. Suppose a home is worth $500,000 and the remaining balance on the mortgage is $300,000. That means that the borrower now has $200,000 of equity in the home. If they now go to a lender seeking to bring the total loan-to-value up to 80%, the lender would offer the borrower a home equity loan in the principal value of $100,000.
Buying an Investment Property with a Home Equity Loan
Now that we have established what a home equity loan is, let’s delve into its various applications. Most borrowers will obtain home equity loans for a range of uses including discretionary spending, retirement/education spending, debt consolidation, wedding expenses, new venture expenses, emergencies, and more. However, a home equity loan can also be used to acquire a second property!
If you are a homeowner looking to invest in a second home beyond your primary residence, you can tap into the equity of your existing property to make the down payment on the new property. The home equity loan may also be used to make home improvements to enhance the value of the property. The extent to which you can do this though depends on a few factors:
- Value of your current home;
- The amount of the mortgage you have already paid back.
- The remaining balance of all mortgages secured by your home
That said though, there are certain challenges involved with obtaining a home equity loan for the purposes of an investment property. Banks and other more traditional lending institutions in some cases may be slightly more hesitant to give out a loan on an investment property as investors are more likely to default on an investment property compared to their primary residence.
In the event of refinancing your current first mortgage for a higher amount, it may be more difficult to qualify for a home equity loan as there may already a large debt outstanding on the borrower’s financial profile (i.e. the current mortgage, credit card debts, car loans, etc.). Therefore, you might be better off turning to an alternative lender such as a trust company or private mortgage lender, though the interest rates that come with those are higher than getting a mortgage from a bank.
When making lending decisions, in addition to loan-to-value, lenders can assess criteria such as debt to income, credit score, and available cash. Hence, if a borrower’s debt to income ratio is already on the higher end from the current mortgage balance and other debts, a traditional bank-type lender may deem the incremental home equity loan to be unfeasible. This is where alternative lenders can be very helpful. They base their lending criteria more on the asset (the home), it’s value, location, condition, and marketability.
Besides a home equity loan which is a lump sum paid to the borrower, there are other alternatives that a borrower can pursue if they wanted to leverage the equity in their home. A few of these are presented below:
- Home Equity Line of Credit (HELOC)
A HELOC can be thought of as a credit card with a maximum limit being a portion of the value of the equity in the home. A borrower can draw on the HELOC and repay funds while the line is open as they please, provided they at minimum cover the monthly interest charges. For property flippers this is an ideal instrument as they can use the HELOC to purchase the property and pay for renovations before paying back the HELOC when they sell off the property. With an open HELOC there are no prepayment penalties, which tends to save borrowers looking to flip a home a lot of money.
- Cash-out Refinance
In a cash-out refinance, the old mortgage is replaced with a new larger one at the current market interest rate. Ideally, this interest rate will be lower, thereby allowing the borrower to save on interest costs, but even if the rates are higher it may be better for the borrower to refinance with a AAA lender rather than taking out a second mortgage through a B lender or private mortgage lender. The incremental amount that is then received can then go towards other purposes such as paying off higher debts (debt consolidation), making improvements on a property, and more.
- Reverse Mortgage
For Canadian homeowners aged 55 and above, a reverse mortgage allows them to access equity and convert it into tax-free cash without the requirement of monthly mortgage payments. In a reverse mortgage, repayment of the mortgage (and interest) is only required once the home is vacated or sold.
Advantages of Using Home Equity
- Opportunity Costs
Rather than dipping into your savings or selling off parts of your investment portfolio, the home equity loan can offer a low-cost source of financing without detracting you from your long-term wealth creation efforts.
Because a home equity loan is secured by the value of your home as collateral, it is less risky to a lender. To this end, interest rates on home equity loans are typically cheaper than ordinary unsecured personal loans or credit cards.
- Boost Credit History
Once a home equity loan is obtained and the borrower starts making principal and interest repayments, they can improve their credit score if the lender reports these loans to Equifax Canada and TransUnion Canada.
- Size of Principal
If the value of your house has gone up significantly since the time of purchase, you potentially have a sizable amount of principal that you can drew from through a home equity loan. Compared to a personal loan, this can be favourable as it allows you to utilize a portion of your net worth that may otherwise be hard to access.
Disadvantages of Using Home Equity
- Investment Risks
Home prices are not always guaranteed to go up over time. Although historical trends may be positive, especially in a major city centre like Toronto or surrounding suburbs like Mississauga, Vaughan, Durham, and more, a decline in the market can lead homeowners to risk being underwater on multiple properties if they have purchased an additional property using home equity.
- Power of Sale or Foreclosure
When a home equity loan is obtained, the underlying property is collateral. Hence, if payments cannot be made on the loan, the property can be taken power of sale or the ownership can then transfer over to the lenders. As such, it is important to do adequate due diligence to ensure that as a borrower, you are financially positioned to make the monthly payments, which are usually interest-only on many home equity loans, and are able to eventually pay off or at least pay down the principal balance of the home equity loan.
A home equity loan can be an effective financing tool for additional properties and/or home improvements if used properly. However, before making such a commitment, it is important to assess your alternatives and ensure that you have the monthly cash flow required to service the loan as well as your mortgage on a timely basis.