Rising interest rates could spell trouble for home equity loans

When the Bank of Canada raised its key overnight lending rates on Wednesday (the second interest rate hike in two months), the central bank also raised concern over household indebtedness.

In its news release it said, “Given elevated household indebtedness, close attention will be paid to the sensitivity of the economy to higher interest rates.”

That’s because each time the bank raises rates, lenders immediately pass them on to borrowers who hold products based on the prime rate. Such as variable-rate mortgages and Home Equity Lines of Credit (HELOCs).

For the rush of Canadians who have borrowed against the equity in their homes and tapped into a HELOC in recent years, ultra-low interest rates were likely a deciding factor.

Surge in Home Equity Lines of Credit

The amount of money that Canadians have borrowed against the equity in their homes has been surging since the start of 2016.

“It’s been fairly easy for consumers to justify this in their minds, “said Scott Hannah, the president of the Credit Counselling Society. “There really is very little motivation to save. It would be easier to take out a HELOC.”

Home Equity Line of Credit Debt Pilling Up Fast

There are about three million active HELOCs across Canada, with an average balance of about $70,000. (Reported by the Financial Consumer Agency of Canada).

Hannah says a responsible way to use the HELOC is to establish a spending limit and a repayment plan. However, he says the concern for some borrowers is that they risk getting into the habit of spending beyond their means.

Unlike with a mortgage, HELOC holders can pay little if any principle each month and instead choose to make smaller interest-only payments. That means balances can build up quickly.

“For a lot of consumers, when you have [a line of credit] and have access to it, it becomes really enticing to use,” Hannah said. “In many cases it’s for expenses that they should be paying out of their paycheques as opposed to using debt for.”

That cycle can be even more difficult to break as interest rates go up and consumers need to divert more of their income to servicing debt.

The warnings keep coming

According to a recent report by the Parliamentary Budget Office, as the Bank of Canada raises interest rates to more historically normal levels (it projects around 3 per cent by mid 2020). Canadians will have to pay more than ever to service their debt.

Canadians currently use 14.2 per cent of their after-tax income to make principal and interest payments on their debt.

“There comes a point that consumers cannot take it anymore and then they default on their mortgages, and then you have a housing crash,” said economist Krishen Rangasamy with National Bank.

While interest rates are still very low, Rangasamy says that if the Bank of Canada is too aggressive with future hikes, borrowers could get into trouble if they keep dipping into the equity of their homes.

“You would ideally want Canadians to have a lot of equity in their homes,” said Rangasamy, “because it reduces odds that you actually default on your mortgage.”

Watch the Bank of Canada

Many analysts agree that raising interest rates could help to discourage Canadians from taking on even more debt.

Equifax Canada says non-mortgage debt rose to the equivalent of $22,595 per person in the second quarter, up 3.3 per cent over the past year.

“Why not start to address those risks right now when the economy can handle it?” said Rangasamy. “What’s the alternative? Do you let consumers credit to keep rising to unsustainable levels?”

How Client First Mortgage Solutions Can Help You

With interest rates rising, are you sure you are in the right mortgage? At Client First Mortgage Solutions we are always looking to save our client money. A Mortgage Analysis might be just what you need. We will analyse your mortgage to see if there is any way to save you money. If a Home Equity Line of Credit is something you are thinking about, make sure you talk with one of our experienced Mortgage Advisors.  They will provide you with all the information needed for you to make the best decision. Contact us today.

Original Article – CBC News – September 9, 2017