What is a Home Equity Loan? A Quick Guide for Canadians

Building home equity is a huge advantage of being a homeowner. As a homeowner with home equity, you get a lot of flexibility. You can use that equity to your advantage by setting up a home equity loan to help out with other areas of your life, often at a much better rate than a traditional personal loan. Here’s what you should know about home equity loans in Canada. 

What is a home equity loan? 

A home equity loan is commonly referred to as a second mortgage. It allows you to take out a loan based on the equity of your home, on top of your first mortgage. The house is then the collateral for both the primary and secondary mortgage which means that failure to pay either back properly could result in the loss of your home. 

Why get a home equity loan? 

A home equity loan is an option that some homeowners look to, especially when it comes to home renovations or upgrades for their homes. Since these types of expenses add to the value of their home, the common consensus is that a home equity loan is a good way to get the money for the projects.  

Home equity loans are most commonly used for expenses related to the home rather than credit card debt, weddings, a child’s college tuition etc. However, there are no rules as to what you can and can’t use your home equity loan for. You can use the money as you please.  

How a home equity loan works 

In order to qualify for a home equity loan, you will need to apply and be approved, just like with your first mortgage. A home equity loan is given out as a lump sum payment and will have a fixed rate (no option for a variable rate) for the duration of the term. 

Since, as the homeowner, you are now responsible for two mortgages, the home equity loan will often have higher rates than your primary mortgage. This is because your level of risk as a borrower has now increased. Should the worst happen and you lose your home, the proceeds of the sale will go first to pay off the first mortgage and whatever is left will go to the second mortgage. This means the second mortgage may not be paid back in full, which is why the interest rates tend to be higher.  

How much can you get from a home equity loan? 

Here in Canada, you are allowed up borrow up to 80% of your home’s value, minus the balance of your first (primary) mortgage. 

So, for example, if the market value of your home is $850,000 then 80% of that would be $680,000. This would be the maximum loan amount. However, you then need to subtract what you owe on your primary mortgage. So if you still owe $400,000 then you could get $280,000. Or, if you only owe $280,000 then you could get $400,000 etc.  

How to Apply For a home equity loan 

You do need to apply for a home equity loan. To do so you can visit the lender of choice. Note that not all banks and lenders offer home equity loans. From there, you can fill out the application form. The approval process will depend on your financial circumstances and your credit score (you need to have a good credit score). You also need to have a minimum of 20% equity in your home to qualify.  

Home equity loan vs HELOC 

One of the big questions when it comes to home equity loans is how they are different than a home equity line of credit (HELOC)? While they are similar in that they both allow you to draw on the equity of your home, these two options work quite differently. 

As mentioned earlier, a home equity loan is given to you as a lump sum. As a credit line, a HELOC allows you to withdraw only as much as you need, then when you pay it back you have the whole amount to withdraw from again when needed. As such, you only pay interest on the amount you withdraw each time. HELOCs also offer interest-only payments, home equity loans do not. 

Home equity loans and HELOCs also both offer different amounts. A home equity loan will allow you to borrow up to 80% of your home’s value. A HELOC only allows you to borrow up to 65% of your home’s market value. 

What are the benefits of home equity loans? 

If you are looking for some extra money, especially if it’s for home improvement projects, then a home equity loan might be a great option. These types of loans tend to have better rates than other loans, even if they are a bit pricier than your typical mortgage. The fixed payment schedule of monthly installments makes it easier for some people to pay off and you can potentially have access to quite a bit of money. 

Potential Risks of home equity loans 

The biggest risk, of course, with a home equity loan, is the possibility of losing your home. Having one mortgage can be quite cumbersome enough for many Canadians. Managing a new mortgage on top of your current mortgage might be tricky. Other disadvantages to home equity loans include the slightly higher interest rate and, when compared to a HELOC, home equity loans aren’t open in the same way. Once you have and use your money, that’s it. You can’t pay it back and access it again when needed. 

Home equity alternatives  

A home equity loan can be very helpful, as can a HELOC as described above. But if you are looking for other options you can also consider the following when it comes to loans using your home equity. 

A reverse mortgage

Individuals who are at least 55 years old may be eligible for a reverse mortgage. This will allow you to borrow up to a maximum of 55% of your home’s equity. Payments don’t need to be made until you either sell the property or pass away. At this point, the estate would handle the repayment of the loan. Keep in mind interest can accumulate very quickly, especially since you don’t have to make monthly payments, and your lender may charge additional fees. 

Cash-out refinance mortgage

This is when you refinance your mortgage for more than what you actually owe. When you do this you can then effectively ‘cash out’ the difference. So, say you borrow $300,000 and your mortgage is $250,000 then you can cash out the $50,000 difference. With a cash-out refinance mortgage you can borrow up to 80% of your home’s appraised value minus the amount of your primary mortgage.