Should you use HELOCs?

If you’re investing in real estate, you have more options when shopping for a loan. If you have the cash on hand for a down payment, you can go the traditional route by getting a fixed- or variable-rate mortgage.

If you don’t have the funds but have equity built up in your home, you 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.”

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 you can take out a HELOC against your 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 yourself in the spotlight with CRA.” So it’s important to track how you use the HELOC if the entire amount isn’t used for investment purposes. If you use 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, you’re 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 you can take out money, pay down and take out again without penalty. For a mortgage, you have a set payment each month based on interest plus principal. And, if you pay off a mortgage before the term is up, you’re 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.

“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 you take out a $100,000 line of credit, and the Bank of Canada moves rates up 0.25%. That quarter point will cost you about $20 extra per month.

“Having that payment go up by $20 is not going to materially impact anybody’s cash flow,” he says. “Rates would have to do something really crazy to be a problem.”

But, if you’re overleveraged with multiple HELOCs on multiple properties, then you 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 you miss a payment on a HELOC, Dietz-Graham says it’s more likely that it can hurt your credit score, compared to a missed mortgage payment.

A client example

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.”