With home equity lines of credit now accounting for 11.3 per cent of total household credit, there’s fear that consumers are taking on too much debt and are overly optimistic about being able to repay the loans.
A recent survey found that many consumers don’t understand how home equity lines of credit (HELOCs) work and are at risk of over borrowing.
The survey, by the Financial Consumer Agency of Canada, says most survey respondents scored less than 50 per cent on a knowledge test of HELOCs, and that more than 25 per cent of those who have the loans made interest-only payments on them. Although 62 per cent of these people said they intend to pay off their loans within five years, FCAC says that’s overly optimistic. More than three million Canadians have a HELOC and owe an average amount of $65,000.
“These results point to a pressing need for financial institutions and FCAC to help Canadians realize that not using HELOCs responsibly can have serious repercussions on their financial well-being,” says Lucie Tedesco, commissioner of FCAC. “Without a repayment plan, consumers may carry debt longer than anticipated and slip into patterns of behaviors that trap them on a treadmill of debt.”
HELOCs are loans that are secured by the borrower’s residential property. Financial institutions sell products that combine HELOCs with traditional mortgages, called a “readvanceable mortgage”.
DBRS Limited reports that since 2017, HELOC balances have been growing at a faster rate than mortgages. HELOCs are the largest type of non-mortgage debt, more than double that of car loans or credit cards.
Used responsibly, HELOCs can save consumers thousands of dollars compared to other kinds of loans. Most of them are tied to a bank’s prime lending rate, which is currently below five per cent. Compare that to credit cards, which can be 25 per cent or more. HELOCs are flexible ñ you can borrow as much as you want up to your credit limit and pay it back any time you wish with no prepayment penalty.
FCAC says most HELOCs are used for home renovations, but 22 per cent of borrowers used them to pay down other debt such as high-interest credit-card balances.
Most consumers don’t have much money available in case of an emergency and HELOCs can be used for a quick, short-term loan if the need arises. Some have used the loans to put toward other financial investments and purchasing property.
“HELOCs provide borrowers with flexibility, as they make it easy to borrow and do not have a fixed schedule of principal payments,” says DBRS in a report. “However, this flexibility also permits borrowers to leverage up easily. It also allows households to carry this debt for prolonged periods of time without having to make a principal payment as these loans, unlike mortgages, are non-amortizing.”
If you have a HELOC tied to your mortgage but want to switch the mortgage to a different lender, you will have to pay off the HELOC completely. If you miss payments on your HELOC, the lender could take possession of your home.
As with all loans, interest rates can go up and your lender may reduce your credit limit. It can also ask you to repay the loan at any time.
FCAC says if you are applying for a HELOC, ask your lender are what’s required to qualify, what’s the best interest rate they can give you, how much notice you will get before an interest rate increase kicks in and what fees apply.
So far most Canadians have been handling their household debt well, but some figures just released by Equifax Canada are worrisome. It found that the 90-day mortgage delinquency rate for mortgages rose by 7.2 per cent for seniors in the fourth quarter of 2018. Overall the rate rose by 1.5 per cent during the quarter, to a rate of 0.18 per cent. The non-mortgage rate was up 0.4 per cent to 1.07 per cent.
While the numbers are still small, Equifax Canada’s vice president Bill Johnston says, “The worm is turning in the Canadian credit market. Bankruptcies are up 15 per cent in the last half of 2018 and the small increase in delinquency rates mask some underlying weakness. Rising delinquency is likely to become the norm in 2019.”
DBRS worries that since consumers can use HELOCs to consolidate debt, “lenders may not observe the initial phases of a borrower’s financial distress, if borrowers use their HELOC to make regular payments on other loans.”
In addition, “In a rising interest rate environment, the interest-only payments for borrowers are also set to rise, which may result in a further burden to borrowers who are carrying a large amount outstanding on their HELOCs. Should interest rates rise faster than anticipated, this could result in an amplified shock to a highly leveraged consumer despite these loans being non-amortizing.”
FCAC says that while most HELOC borrowers in the survey said they used their loans as intended, some borrowed more than expected. An argument can be made that money spent on home renovations is helping to increase the value of your home and your overall financial picture, but as with all loans, you must be realistic about your ability to repay.
“Borrowers would benefit from more upfront information about HELOCs and should take steps to learn about them,” says FCAC. Repayment plans that include making regular principal payments can help HELOC borrowers mitigate the risk of over-borrowing, debt persistence and wealth erosion.”