How Home Equity Loans Work
By Andre Mayer • Bankrate.com

A home can be a source of great pride and satisfaction, and if you're looking to finance a renovation, a new vehicle or some unforeseen emergency, it can also be a source of equity. A home equity loan allows you to leverage your property's equity - i.e. the difference between the home's appraised market value and your outstanding mortgage balance - to secure a loan.

Why do people opt for home equity loans? Simply put: the interest is lower. Credit card rates currently hover around 17 percent. A home equity loan or line of credit, on the other hand, can range from the prime business rate set by the Bank of Canada, known simply as "prime" (currently 4.25 percent), to prime-plus-three (which would be 7.25 percent). The rate for a home equity loan is often better than that for a personal line of credit. The rate you get will depend on your credit history, your earnings and whether you have existing assets with a particular lending institution.

Home equity loan vs. home equity line of credit

The difference between a home equity loan and a home equity line of credit is that with a loan, once you've used a percentage of the loan, you won't be able to access it again. For example, if you took out a $5,000 loan to fund a vacation, whether you've repaid a fraction or the entire sum, you have to re-apply to get another loan. With a home equity line of credit, once you've used it, you can spend as much as you've paid back. If you used $8,000 and repaid $5,000, you have access again to $5,000.

Given the reduced interest, many people use a home equity loan to consolidate their debts. They utilize it to settle their other arrears (credit cards and lines of credit) and combine their entire debt load and refinance it at one reasonably low interest rate.

The home equity loan or line of credit must be tied to your principal residence; banks don't normally secure such loans to rental properties. The loan is generally repaid in monthly installments, and must be entirely settled when you move out of the house.

Why use a home equity loan?

Many people take advantage of this financial instrument for renovations or the purchase of a car. Because it is secured to a house - for most people, the largest asset they'll ever possess - this type of loan allows for a longer amortization. The typical car loan is amortized for a maximum of seven years; with a home equity loan, you can amortize it up to 25 years. You can make smaller payments over an extended period, but that also means you'll incur more interest.

After 25 years, you're obliged to renegotiate your loan. But there's nothing stopping you from reapplying sooner. If you got a $50,000 home equity loan five years ago and in the interim repaid $30,000 of it, you can apply to be bumped back up to the $50,000 plateau, but at more current rates (which can be good or bad, depending on the economy).

Need more cash? A future increase in income or home value can mean a larger loan

In most cases, Canadian regulations stipulate that the combination of a primary mortgage plus a home equity loan on a given residence cannot exceed 75 percent of the home's market value. For example, if your house is worth $400,000, and you have a $200,000 mortgage, your home equity loan will not be greater than $100,000.

But there are ways of accessing more cash. In the last six months, some banks have introduced a product called a high-ratio home equity line of credit. It's intended for borrowers who may not be able to pay much more than the interest in the short term, but will be capable of bigger payments at a future date.

"It may appeal to those who anticipate a higher income in the future," says Doug Sherrington, a branch manager at TD Canada Trust. "For instance, a recently graduated doctor or lawyer whose earning power will likely increase as they progress through their career."

Homeowners can also take advantage of a surge in home prices to score a larger loan. If your property is appraised at $400,000, the maximum combined mortgage cannot exceed $300,000. But if the home's value rises significantly, you may be able to access a bigger mortgage. Taking our example of the $400,000 house, if, after a few years, its value increases to $500,000, some lending institutions will allow you to register the home equity loan for more than $100,000, if you can demonstrate the rise in value.

"They won't let you have access to it until you can prove you've got that added equity," says Paula Roberts, a mortgage consultant for Mortgage Intelligence. "You have to have an appraiser go out and appraise the property."

Andre Mayer is a freelance writer based in Toronto, Ontario.