If you have a lot of equity in your home, you might wonder if you can use a HELOC to buy a second home. Perhaps you are interested in purchasing a cottage or an investment property — which would be the fastest way to secure a down payment. While it is possible and has some benefits, there are plenty of risks to be aware of before choosing this route. So here is what you need to know about using a HELOC to buy another property.
What is a HELOC?
A Home Equity Line of Credit, or HELOC for short, is a type of secured revolving credit. The lender uses your home as collateral against the loan, so your loan value will depend on your equity in the home.
To qualify for a HELOC, you must have an acceptable credit score, proof of sufficient (and stable) income, and an acceptable level of debt compared to your income. Like getting a mortgage, you must also pass a stress test.
In Canada, lenders use a ‘stress test’ to calculate whether borrowers can afford their mortgage payments if interest rates rise. The qualifying rate differs for insured and uninsured mortgages.
For uninsured mortgages, you can calculate the stress test using the higher value of the benchmark rate of 5.25% or the borrower’s current interest rate plus 2%. For insured mortgages, the qualifying rate is the higher value of the benchmark rate or the borrower’s current interest rate. Passing the stress test is crucial for securing a mortgage, and failing may require a larger down payment or a smaller mortgage.
What are the Advantages of a HELOC?
A HELOC can be a desirable option for individuals looking to borrow money. HELOCs typically have lower interest rates than credit cards and other loan options. HELOCs are also a type of revolving credit. This means you only need to apply once and have access to the credit as you need it, so long as you continue to pay it off.
Can You Use a HELOC to Buy Another Property?
Yes, it is possible to use your HELOC to buy a second home in Canada. You can technically use your HELOC for whatever you like. Typically, people will use their HELOC for home updates and renovations. Still, it is also possible to use a HELOC to buy a second home, like a vacation home or investment property.
Using your HELOC can be helpful when you need more cash to pay for a second home. For example, the money is invested, and you cannot (or do not) want to access it. In this case, you could use your HELOC from your first home to get the funds for a down payment on a second property.
You can also use a stand-alone HELOC as a substitute for your mortgage on the second property. If you choose this route, you will need a higher minimum down payment of 35% of the purchase price or market value. However, a HELOC can offer you more flexibility when paying off the principal without worrying about prepayment penalties.
Of course, like every financial product, using your HELOC to buy a second home has advantages and risks that you must be aware of.
Pros and Cons
Pros
- Good option if you need access to cash but have plenty of equity in your current property
- Allows for flexibility when it comes to payments
- Don’t have to worry about any prepayment fines that are typically attached to a mortgage
Cons
- Interest rates attached to your HELOC are frequently higher than interest rates on a mortgage
- You are putting your first home at risk since it is the collateral for the HELOC. Should something happen, you could lose both properties
- You also need to think about what happens if you sell the first property while still paying for the second, as all financing (including the financing used to buy the second home) must be paid off in full
- Setting up a HELOC to finance a second home will incur additional costs like appraisal, title search, administration and legal fees
Other Options as a Homebuyer
A HELOC isn’t the only way to use equity to buy a second home. Other options that might be worth considering include the following.
Refinancing Your Mortgage
Refinancing your mortgage is when you replace your current mortgage with a new mortgage. You can stay with the same lender or switch lenders (which may incur an additional fee unless your mortgage is up for renewal). When you refinance, you can get a new mortgage with up to 80% of the value of your home, which may give you the capital required for purchasing another home.
Taking out a Second Mortgage
You can also take out a second mortgage, which means taking out an additional loan on your current property. Second mortgages can be more challenging to get and are seen as riskier, so they often have higher interest rates. This is because, should you default on your loan, the second mortgage only gets paid after the first mortgage.
A Reverse Mortgage
A reverse mortgage allows homeowners aged 55 or older to borrow up to 55% of their home’s value. Interest rates are higher than what you would pay on a traditional mortgage, but you do not need to make regular payments (although interest will continue to accrue until it is paid off). However, the loan does need to be paid back in full should you move or pass away.
TL;DR
Yes, you can use a HELOC to buy a second home in Canada. The advantage of doing this is it allows you access to cash you may not otherwise have, and payments can be much more flexible than a traditional mortgage requires. However, it can be risky and may incur additional fees.
If you are in the market for a second home, such as a cottage or investment property, then a HELOC can help buy the additional property. For some individuals, it might be a good option. However, there is a lot to think about when going this route. First, consider if you can manage this debt load and research how much it will cost you compared to your ability to pay it off. While the flexibility is great, the interest rate is higher, and you also need to add on the additional HELOC fees, which might be a bad deal in the long run.
