Last month, the Bank of Canada issued a report highlighting the explosive growth of home equity line of credit use and mortgage refinancing in the past decade, which have surged from $8 billion in 2001 to $64 billion in 2010.
Canadians appear to be using these loans for two main reasons. They are either paying down other higher interest loans, such as credit card debt, or using the money for everyday spending.
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My first experience with a home equity line of credit was back in late 2005. After buying a house two years earlier, it surged in value during the economic boom in Alberta, rising from $129,000 to $190,000.
Using a Home Equity Line of Credit to Consolidate Debt
At that time, my wife and I still owed tens of thousands of dollars in student loan and credit card debt, so we took out a home equity line of credit to consolidate most of our debts. This was a smart decision that helped save us a few hundred dollars in monthly payments by lowering our overall cost of borrowing.
Just be cautious when using this approach. You still need the discipline to repay the line of credit or you might find yourself right back where you started.
Our $25,000 credit line was borrowed at prime rate, and two years later we rolled the loan back into our mortgage at renewal time. The bank didn’t close the line of credit after this. Instead, they suggested we keep it open just in case something comes up.
Using a Home Equity Line of Credit as an Emergency Fund
Our finances weren’t perfect by any stretch. One or two missed pay cheques would have caused serious damage to our finances. However, building a cash emergency fund never became a priority for us because we knew we had a line of credit to fall back on.
So for the next five years our home equity line of credit remained untouched and we resisted the urge for that something to come up. During that time, I convinced myself that a home equity line of credit was the perfect emergency fund. Here’s why:
- A line of credit is the most affordable way to borrow for short term needs – with rates as low as prime or prime + 1%
- Accessing funds from your line of credit (once it’s set-up) is as simple as making a transfer online
- Re-payment of your line of credit is very flexible – you can pay as much or as little as you like.
- The opportunity cost of carrying thousands of dollars in a so-called high interest savings account did not seem appealing.
Using a Home Equity Line of Credit as an ATM
Meanwhile we watched as our friends and colleagues (and the rest of the country) tapped into their credit lines like a giant ATM and use it for home renovations, new vehicles, family vacations or to further their education.
In The Wealthy Barber Returns, author David Chilton writes that with our increasing debt load and infatuation with buying stuff, not only is a line of credit a bad idea, but it’s leading to over-consumption and we’re now carrying debt along side of our savings.
HELOC: Friend or Foe?
A home equity line of credit has its advantages. It’s an easy way for homeowners to consolidate high interest debt. When used responsibly, an untapped line of credit can make for a good safety net in case of emergency.
However, the easy access to credit and flexible repayment terms can make HELOC’s very dangerous. Many consumers dip into their line of credit and then quickly find themselves living at their limit. Then when the money runs out, they increase the credit limit and repeat the cycle.
Our home equity line of credit was closed when we sold our home last year. We rented for three months while our new house was being built, and over that time we saved up a few thousand dollars that we now keep in a high interest savings account.
We no longer have a line of credit, even with more than 25% equity in our home. Our new financial plan includes keeping cash reserves on hand rather than relying on a line of credit for emergencies. We want to pay cash for any major purchases in the future, like for a new car, basement renovations or a big vacation.
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For many people, a home equity line of credit is an easy way to fall into a debt trap. Be cautious. Don’t use a HELOC to continue increasing your debt load or to support a gap between your income and expenses.