Not all lines of credit are created equal

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Canadian Real Estate Wealth contributor Peter Kinch explains that brokers working with investors looking for extra leverage to make their next investment must look at the nuances and differences offered to them in the form of lines of credit

The Minister of Finance and the Governor of the Bank of Canada have both recently expressed concerns recently over the amount of household debt that Canadians have been carrying. Indeed, one of the predictable results of an economy in which interest rates are kept low for an extended period of time is that consumers will find it hard to resist the temptation of borrowing beyond their means. Although it is true that there is an increased trend among Canadians to access equity in their homes as if it were an ATM, it is important to point out that there are two very distinct differences between those who borrow to support lifestyle and those who leverage to increase wealth

Over the past few years the amount of Canadians who have taken out a line of credit on their home for anything from home improvements to vacations abroad has increased to the point that the government has raised a caution flag. And so far in 2012, there is no indication that the government will back down on its cautioning.

Brokers and their real estate investors, however, need to be aware of who the government is really targeting: the homeowner who is using their home equity as a means to subsidize their current lifestyle of consumption. The government should be concerned with these behaviours, but they should not be confused with the prudent investor who recognizes that utilizing home equity is an excellent way to increase net worth.

While the government worries over the ‘lifestyle subsidizer’, the broker and savvy real estate investor recognizes that this period of historically low rates creates a unique opportunity to leverage home equity into wealth-creating real estate investments. Brokers and investors understand that in order to purchase cash-flowing rental properties they will need to either come up with the down payment themselves or attempt to find a joint-venture partner.

The simplest and least expensive source of capital (outside of cash on hand) is home equity. As such, it is common for almost every investor to set up a line of credit on their home in addition to their mortgage as a way of converting home equity into increased net worth. But a lot of investors do not understand that not all lines of credit are created equally.

Two types

There are two different types of lines of credit (LOC) in the Canadian mortgage market and it is critical for a savvy real estate investor to understand the difference. One is a traditional ‘static LOC’ and the other is a ‘re-advanceable mortgage/LOC combination’. On the surface, the two may appear similar, but what makes them different is critical to an investor.

A static LOC is the LOC that most homeowners are familiar with and one that the majority of banks and lenders have been offering up for years. It is, quite= simply, a line of credit that is placed behind the first mortgage. If a homeowner has more than 80 per cent of equity in their home they can apply to access that home equity (up to 80 per cent) in the form of a line of credit.

The challenge with a static LOC – also known as a home equity LOC or HELOC – is that it is static – meaning that if the amount of equity you have in your home were to increase over the course of the mortgage, the maximum amount of money that you would be able to draw out would remain the same, regardless of how much you may have reduced the original mortgage amount by.

For example:

Home value = $400,000

Mortgage amount = $250,000

80 per cent of home value = $320,000

Amount of accessible home equity = $70,000

In the preceding example a HELOC can be arranged for $70,000. This in itself is a fairly straightforward transaction and one that the majority of Canadians undertake when arranging for a LOC. However, let’s assume that the homeowner in the above example took advantage of every pre-payment privilege available to him or her and also had excess cash available through employment bonuses or commissions. Let’s further assume that this homeowner was able to pre-pay as much as $50,000 over the next two years of their mortgage and were now at a point where they wanted to access some of the additional $50,000 in built-up equity to purchase an investment property. Unfortunately for our investor, since the product they chose was a static HELOC, the majority of lenders would require them to re-apply to have the limit on their HELOC increased.

Aside from the inconvenience of a new application process, which could be declined if there were any changes in employment (such as shifting from an employee to being self-employed or simply having a spouse go on maternity leave), your investor would also be subject to additional legal and appraisal costs – all this because they did not get the right advice in the first place.

What they should have arranged is a re-advanceable mortgage/LOC combination. The difference is simple and obvious, but unfortunately many Canadians are still not familiar with the fact that they exist. As the name suggests, a re-advanceable mortgage is created in such a way that every dollar of equity that is created by paying down the mortgage portion of the loan is re-advanced to the line of credit.

In the example below, the $50,000 that was used to reduce the mortgage would be automatically readvanced to the client and made available to them in their line of credit.

Mortgage        LOC

$250,000         $130,000

$50,000

$200,000         $70,000

The original mortgage would be structured exactly the same with $250,000 set up as a mortgage amount and $70,000 made accessible in the LOC. The difference with the re-advanceable mortgage is that as the $50,000 of equity is paid off the mortgage, the accessible equity in the line of credit is increased by that same $50,000. In other words, every dollar of equity that is paid off one’s mortgage is automatically re-advanced to their line of credit. There is no need to re-apply to have it readvanced – it is done so automatically. And the best part is that any time one uses money from their line of credit for an investment that has the intention of making money – the interest on the line of credit is tax-deductible – a process that is commonly referred to as the ‘Smith Manoeuvre.’

The proper use of this product is critical for the real estate investor as it addresses two critical areas that often concern them. The first and most obvious is the fact that access to money for down payments is one of the biggest obstacles to the real estate investor. Utilizing a re-advanceable mortgage/LOC allows an investor to build up funds toward their next down payment simply by making their mortgage payment every month and allowing it to accumulate in their LOC over time. The second, less obvious advantage of this product is that it should forever eliminate the argument among couples over whether they should use a particular lump sum of money to pay down their mortgage or invest.

Proper utilization of this product will allow your clients to do both. Simply apply the excess cash onto a principal residence mortgage, thereby reducing immediate mortgage costs, and then have those same funds re-advanced to a line of credit where it can remain indefinitely available until such time that an investor is ready to invest. It should be noted that there is absolutely no additional cost to having the limit on your line of credit increased. A person only pays interest on the amount of money they access and only when it is accessed.

It is for this reason that investors looking to access potential equity for the purposes of investing should always use this tool instead of refinancing with a brand new mortgage. If the entire amount of equity were to be accessed in the form of a mortgage, then one would be paying principal and interest payments on the entire amount from the very start of the mortgage.

When used for the purpose of making an investment that has the intention of making money, not only is this a prudent tool for tax purposes but it is also a tool that will help add to an investor’s net worth.

As we move into the spring and summer markets, remember, you’ll continue to read headlines about how Canadians are using their homes as ATMs and we should all be cautious about accessing too much equity in our homes to subsidize our lifestyles. Your investors, on the other hand, will be utilizing the right tool to access equity to purchase properties that have enough cash flow to service the debt on the subject property and pay the interest on the line of credit. But don’t worry too much about what you read in the headlines, they’re talking about the other guys.

  • Richard Watson on 2012-04-22 12:16:57 PM

    I have a HELOC and was told I could not use it for a down payment on an investment property. Is there a certain approach to doing this?

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