MORTGAGE & FINANCE: Home Equity Lines of Credit, In Context

Mortgages, which were considered "good debt," are being swept into the "debt is bad" category. Home equity lines of credit, which were considered "good mortgages," are being swept into the "debt feeds panic" category, and who knows what’s next?

What’s next for me?The Bank of Canada, which is in charge of keeping us fiscally safe and progressive, has some control over the interest rates consumers pay, but it doesn’t know how the global financial crisis is going to play out. Its winter 2011-2012 quarterly report, "Special issue: Household Finances and Financial Stability Household Finances and Financial Stability," caused a new wave of media "debt" stories and added another layer of panic, but we still don’t know how this will all end.

Where you are financially (and that includes how in debt you are) and which financially-significant moves you want to make in the next year or so, determine how vulnerable you are to short-term interest and property value issues raised in these uncertain times. Your level of financial flexibility will determine whether you can survive anything that comes, or if you’ll find speed bumps ahead.

Are you financially ready for the unexpected - good or bad?

• Do you have a three-to-six-month emergency fund to tide you over if an income problem or sudden expense arises?
• Have you got the money to take advantage of renovation or energy saving programs, or other valuable opportunities?
• Do you have the resources to cash in on travel or car bargains, or will you be cash-poor?

If you answered "yes" to these questions, your financial flexibility will get you through some pretty tough times.

If your "yes" answers relate to being bailed out by a home equity line of creditor HELOC, not by accessing cash and assets, you’re counting on debt flexibility, not financial resources, to preserve what you own and achieve what you want. These and issues like them are precisely why HELOCs are popular. However, if a HELOC is your only financial backup, you may be on shakier ground that you realize.

HELOC Workings

The name "home equity line of credit" explains that property owners borrow against existing home equity, or accumulated real estate value. The lender registers this debt against title to protect its investment, and charges fees and interest to homeowners for the privilege of borrowing their own equity.

Lines of credit can also be extended against income with no real estate involved, but rates and terms may not be as attractive as with HELOCs where the debt is fully secured against real estate. Qualification for a HELOC involves two factors:

Available Home Equity: Lenders decide how much is enough when it comes to home equity. The more equity the property owner wants access to, the more expensive borrowing can get. Usually, borrowing less than 50 percent of market value is easier than trying for more. Lenders valuate property based on sale prices that could be achieved in quick sales in most markets. Lenders use real estate data to project property-value increases over time for specific properties, so they may lend more on one location than another. This means as real estate drops in value and or markets slow, lenders get nervous about recovering the amount lent, their costs, and their projected profit.

Debt Service: Lenders want to guarantee interest will be paid and the amount borrowed will be repaid. Traditionally, lenders concentrate on credit scores and proof that property owners have enough verifiable income to "service the debt," that is repay the amounts withdrawn and the interest. When job losses increase and economies slow, lenders worry property owners may lose earning power. Changes in earning status can also herald adjustments to borrowing limits and increases in interest rates. For instance, age 65 traditionally signals an income drop as people retire into pension incomes often representing less than 50 percent of earned income.Lenders apply these two key factors to their lending formula to establish the amount of home equity which may be withdrawn by the owner(s). Terms and conditions may set minimum or maximum withdrawal amounts for each month or year. HELOC lenders usually require interest be paid each month, but details regarding repayment of borrowed home equity may not be specified. The terms and conditions in a HELOC contract also gives the lender the power to decide when to reduce unused borrowing room or to end the HELOC. Additional triggers for ending the HELOC are linked to failure of borrowers to meet their specific responsibilities, including keeping property taxes and insurance up to date. Lenders have the power to modify existing HELOCs whether they choose to use it, or not.
Current concerns about declining real estate values feed lender fears that their projections of market value, which ensure their risk of loss is low, may represent inflated market value. Since interest rates would have to bump up significantly before affordability issues arose for most HELOC holders, there is little immediate concern for lenders. Media speculation about "the bubble bursting" or "the balloon leaking" continues, but no one knows for sure.
What you do want to be sure about is that you know what rights the lender has, and which responsibilities you have toward the lender. This is not a time for HELOC surprises.
FYI: Reverse Mortgages vs HELOCs
Question: Why would a property owner arrange a reverse mortgage when they could have a HELOC?
Answer: The quick answer is that they probably wouldn’t since HELOC are less expensive. However, traditional lenders are ageist, and it gets progressively more difficult to arrange traditional mortgage variations like HELOCs when you’re older. Reverse mortgages favour those over age 55 or 60, particularly those over 70. Traditional mortgages like HELOC can also be less practical because income may be too low to qualify to borrow enough money to make the cost worthwhile. If income is low, making regular HELOC payments may be a challenge.

If the only way to achieve the primary goal of staying in the home you love - no other will do - is to arrange a reverse mortgage, then this may be the best solution. Reverse mortgages do not require monthly repayment or qualification by income. The advantage with a reverse mortgage can be that, even if the home equity runs out, you may still be able to stay in that home (check your reverse mortgage contract for details). In contrast, at the discretion of the lender, unused HELOC lending room may be cancelled or the HELOC may be ended.

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