Clients investing in real estate have more options than other investors when shopping for a loan. If they have the cash on hand for a down payment, they can go the traditional route by getting a fixed- or variable-rate mortgage.
If they don’t have the funds but have equity built up in their homes, they can consider a home equity line of credit (HELOC).
“It’s one way to tap into the debt equity you would have in a property,” explains Aneta Zimnicki, mortgage agent at Dominion Lending Centres in Toronto. “If you have the right investment vehicle that yields returns higher than the cost of borrowing, then it’s a way to invest without having to essentially use any of your funds” (see “Risks of borrowing to invest” on our tablet edition.)
Here’s how it works: a HELOC is a secured line of credit against your current property. That means “the lender can offer you a much lower rate because of the collateral,” says Zimnicki. Typically the rate is prime plus one, or prime plus half, depending on the lender.
So a client can take out a HELOC against her primary residence, for instance, and use those funds as a down payment for an investment property. And there’s a tax benefit if you use the funds from a HELOC to invest, just like if you use a mortgage to invest. In both cases, the loan interest is tax deductible.
Zimnicki warns any investment interest deduction can “put you in the spotlight with CRA.”
So tell clients to track how they use the HELOC if the entire amount isn’t used for investment purposes. If a client uses 10% of the HELOC to buy a fridge, for instance, then that comes under personal use and 10% of the interest isn’t tax deductible.
Also, payment terms for a HELOC differ from a conventional mortgage.
Most HELOCs in Canada have an indefinite term. So, clients are on the hook for interest only, says Amy Dietz-Graham, investment advisor at BMO Nesbitt Burns in Toronto. And the line of credit is open, so a client can take out money, pay down and take out again without penalty (see “Definite or indefinite?”).
For a mortgage, the client has a set payment each month based on interest plus principal. And, if a client pays off a mortgage before the term is up, she’s subject to penalties.
But there’s a risk with HELOCs. Since they’re based on interest rates, payment amounts can fluctuate. The risk is similar to variable-rate mortgages, which also depend on interest rates (see “Mortgage vs. HELOC”).
“You have to be prepared for that and make sure you’ve got enough cash on hand so you’re not in a situation where you’re not able to make the payments,” warns Dietz-Graham.
David Stafford, managing director of Real Estate Secured Lending at Scotiabank in Toronto, notes that while there is interest-rate risk, it’s minimal. Say a client takes out a $100,000 line of credit, and the Bank of Canada moves rates up 0.25%. That quarter point will cost a client about $20 extra per month. “Having that payment go up by $20 is not going to materially impact anybody’s cash flow. Rates would have to do something really crazy to be a problem.”
But, if the client is leveraged with multiple HELOCs on multiple properties, then she may be in trouble if rates rise. And while HELOCs are always reported to credit bureaus, sometimes mortgages are not (typically if the mortgage is with a smaller lender). So if a client misses a payment on a HELOC, Dietz-Graham says it’s more likely that such an error can hurt her credit score, compared to a missed mortgage payment.
Mortgage vs. HELOC
|Mortgage||HELOC (indefinite term)|
|Borrowing||Full amount is given; cannot withdraw more unless terms are renegotiated||Clients can choose to withdraw at their leisure, up to the maximum amount|
|Payment||Interest + principal||Interest only|
|Rate||Fixed: rate is guaranteed Variable: rate fluctuates based on prime lending rate||Rate fluctuates based on prime lending rate|
Zimnicki adds advisors must start the conversation about whether to take out a HELOC for investment purposes with clients early, especially since they may be more likely to get approved for one before they own multiple properties.
“Ask for money when you don’t need it,” she advises. “When someone says, ‘I’ve used up all my cash, now I want to tap into my home equity,’ possibly it could happen. But an optimal setup most likely would have happened earlier in [the client’s] portfolio.”
Putting a HELOC to work
A HELOC can be used to invest in vehicles outside of property. One of Dietz-Graham’s clients did just that. The client had paid off the mortgage on his $2-million primary residence and decided to take out a HELOC. He borrowed $100,000 to invest solely in companies.
“Given that rates are so low, it gave him the opportunity to invest in high-quality companies that were paying higher dividends than what the interest rate was,” says Dietz-Graham.
His current rate is 3.2% (prime plus 0.5%), and the interest is tax-deductible.
“He invested this money into a balanced portfolio with a long-run target return between 5% and 8%,” she says.
“Given the client’s net worth, the amount he borrowed was appropriate and he fully understands the risks of using borrowed funds for investing, because it’s definitely not a strategy for everyone.”
Definite or indefinite?
According to the Financial Consumer Agency of Canada, there are two types of HELOCs. One comes with a definite term, which means that a client has to pay it back in full by a predetermined date (five to 25 years, depending on the lender). The time before the HELOC matures is called the draw period, during which a client can withdraw up to the maximum credit limit and only has to pay the interest. If she pays down the HELOC, she can withdraw again before the maturity date.
However, most Canadian lenders offer HELOCs with indefinite terms. Similar to a credit card, they come with revolving credit and there is no maturity date. Again, the funds are available up to the maximum amount the client has been approved for.
So, a client can borrow, pay down and borrow again indefinitely. And while the client is only required to pay the interest each month, if she pays down principal, that can open up capital to reinvest.
For instance, say a client has paid off the mortgage on her $400,000 primary residence. Using a HELOC with an indefinite term, she borrows up to the maximum 65% of her home’s appraised value—$260,000—and invests the entire amount in a rental property. After three years, she’s used the returns from the rental to pay down her HELOC, so she has the same $260,000 available to invest in a third property.