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What is a home equity loan?

Posted on 3 July 2022

Written by Ashvin Sharma

A home equity loan is a loan that is secured by the equity in a property you own. The idea behind a home equity loan is that it is a way to borrow potentially a large amount of money quickly at a low interest rate. This is contrary to alternative borrowing options like credit card debt or unsecured loans. Although it seems like a great idea, there are a number of points to be wary of when it comes to home equity loans. For instance, lenders can change the terms and conditions of your loan with little notice. So, what is a home equity loan? In this article, we explore what a home equity actually is, what you need to know before taking one out, and how it differentiates from a home equity line of credit (HELOC).

What is a home equity loan?

A home equity loan is an amount of money borrowed from the equity in your property. When you build equity in your property, you can benefit from it by either selling your property or taking out a home equity loan. It is a good option if you are a homeowner and need access to a sizeable amount of money but do not wish to sell your home. In Canada, this is often known as a second mortgage or an add on mortgage. You can typically borrow up to 80% of your property’s equity, which you pay interest on. It differs from a home equity line of credit (HELOC) as you are given a one off lump sum payment. With a home equity loan, you need to repay agreed amounts on a schedule, inclusive of interest charges. Often, home equity loans are used if you are looking to do some work on the property in order to increase its value, like a bathroom or kitchen renovation. Home equity loans can also be used for things like credit card debt consolidation, or for paying for further education. One thing to be wary of with home equity loans is that if you fail to pay for your mortgage, you could lose your property altogether. Home equity can also be used in order to gain debt relief. For instance, you may wish to pay off any debts that are attached to high interest rates. It is also a good way of avoiding bankruptcy if you are struggling financially but are a homeowner.

How does a home equity loan work?

The first step of a home equity loan is determining whether or not you actually have home equity. Home equity is the difference between the balance remaining on your mortgage, and the value of your property. You build equity over time by paying off your mortgage as the value of your property increases. If you do qualify, you will need to apply for a home equity loan from a lender or financial institution. If you are approved, you will receive a one-off lump sum with an interest rate that is either fixed or variable over an agreed period of time. Once you have received your cash, you will then need to make your payments on time, leaving you essentially with a primary mortgage and a second mortgage of repayments. A benefit of a home equity loan is that the interest rates are usually much lower than those associated with credit cards, although usually this interest rate is greater than that of a primary mortgage due to the greater risk associated with it. Should you miss your payments and your home is repossessed, your primary mortgage will be paid first of all. Your home equity lender would then receive the remaining amount. In Canada, you are able to borrow 80% of your property’s equity, aside from the remaining mortgage balance. You can use valuation tools and home equity calculators online to estimate the amount of property equity you may have.

What are the advantages of a home equity loan?

There are a number of advantages of a home equity loan. Of course, first and foremost it enables you to receive up to 80% of your home equity in one straightforward payment. This comes at a lower interest rate than other forms of borrowing including credit cards, personal loans, and lines of credit. Home equity loans with a fixed rate have the additional benefit of allowing you to plan your payments across a set period of time which can help with budgeting. By using a home equity loan efficiently, you can increase the value of your home say by having a renovation, which could mean you make profit if you are looking to sell your house. When used wisely, home equity loans can really pay off.

What are the disadvantages of a home equity loan?

Home equity loans also have their disadvantages. To begin with, not all financial institutions and banks in Canada offer home equity loans. Where they are offered, the interest rates for home equity loans are much higher than those of primary mortgages. This is because of the increased risk associated with home equity loans (or second mortgages), as primary mortgages will take priority should you struggle to make your repayments. Another disadvantage of taking out a home equity loan is the fact that your home is the associated asset. This means that you risk foreclosure should you default on your payments or your circumstances change. Finally, taking out a home equity loan typically brings about fees – this includes appraisal and legal fees. All of these disadvantages should be points for you to consider ahead of taking out a home equity loan.

What is the difference between a home equity loan and a home equity line of credit (HELOC)?

A home equity line of credit, also known simply as a HELOC, offers a similar way to borrow based on the equity of your home, although there are some key differences. While a home equity loan enables you to borrow up to 80% of your property’s equity, with a HELOC, you may borrow up to 65% of your home’s value. Another advantage of a HELOC is that you do not need to determine exactly how much you want to borrow. They work in a similar way to credit cards in the sense that there is revolving credit. This means that you have a limit, but you can continue to withdraw various amounts of money as you need it. This can be a good option should you be carrying out a renovation and do not know initially exactly how much money you will need. For home equity loans, you will pay back both your principal payments with interest, yet for a HELOC, you can pay back interest-only payments for a period if you wish. While this offers greater flexibility, it can also extend the duration of your debt and can quickly add to the overall value of the amount you owe. It is also difficult to find a HELOC on a fixed rate, which adds greater risk and potential expense to your repayments.

What are the best alternatives to a home equity loan?

As well as a HELOC, there are a number of alternatives if you do not feel a home equity loan is the right option for you. These include:

  • Reverse mortgage – if you are aged 55 or above, you may qualify for a reverse mortgage which can enable you to borrow up to 55% of your home’s equity. The difference here is that you do not need to make repayments until you sell the property, or you die. There are often fees involved, and interest can quickly add up.
  • Cash-out refinance mortgage – when you refinance your existing mortgage for more than is owed, you are able to cash out the difference. This enables you to borrow up to 80% of the difference, potentially at a low interest rate. Do note there will likely be fees if you refinance your mortgage before the end of its term.
  • Blended mortgage – you may be able to combine your existing mortgage rate with a new mortgage rate. This becomes blended into a single mortgage with a new rate that is in between both mortgage rates. This way, you can avoid prepayment penalties as you are not breaking your original mortgage contract.
  • Speak to a Licensed Insolvency Trustee Licensed Insolvency Trustees are the only professionals in Canada legally able to file all forms of debt relief. You need to ask yourself why you are looking to borrow a large amount of money, and if it is completely necessary. If you are struggling financially, there could well be a form of debt relief that is more appropriate in reducing your overall debt and putting you on the pathway to financial freedom.

Before you take out a home equity loan, book a free consultation with Spergel. Our experienced Licensed Insolvency Trustees have over thirty years’ experience of helping Canadians with home equity loans and their alternatives. We will work with you to review your financial circumstances, and can advise you on the best way to borrow without accumulating too much debt. Reach out today – you owe it to yourself.

Ashvin Sharma

Ashvin Sharma

Ashvin Sharma is a Chartered Insolvency and Restructuring Professional and LIT (Licensed Insolvency Trustee) overseeing all of Spergel's offices in the Greater Vancouver Area and British Columbia. He is also our resident expert on homeownership debt and health debt. In his spare time, Ashvin loves to play sports, spend time with family and friends, and serves as a volunteer coordinator for "Free-Them", a Canadian organization committed to raising awareness about human trafficking.

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