Cory Cook’s initial plan was to build out his backyard deck. But as the pandemic drags on, he’s looking to overhaul his entire basement. “The renovated basement would generate rental income and offer financial security in the event of a job loss,” says the 43-year-old Toronto father of two.
To fund his home improvements, Mr. Cook, who helps businesses invest in energy efficiency, took out a $300,000 home equity line of credit (HELOC). After careful consideration, he’s decided to pay for the $10,000 deck from his savings and to tap his HELOC for the upcoming basement reno, an estimated $150,000 project. He’s hoping the reno will start in March. The remaining $150,000 of the HELOC was earmarked as a fund to provide short-term financial security in case the couple lost their jobs during the pandemic.
Spurred by soaring real estate values and low interest rates, Canadians like Mr. Cook have long been using HELOCs, which allow people to borrow against the equity they have in their homes, to fund big costs like renovations.
But with many people now living and working from home, packed in with partners on Zoom calls or kids at virtual school, the COVID-19 pandemic lockdown has led to a boom in home improvement projects. That has in turn galvanized borrowing, with home owners taking on debt at a time when the economic outlook is uncertain, despite remarkably low interest rates.
Although HELOC borrowing in Canada was high before the COVID-19 outbreak, the pandemic has created a whole new cohort of reno consumers, says Ron Butler, a broker with Butler Mortgage Inc. in Toronto.
According to the Office of the Superintendent of Financial Institutions (OSFI), the outstanding balance on Canadian HELOCs stood at $272-billion as of November, 2020. That’s up from $268-billion of outstanding HELOCs in January, 2020 - a 0.75-per-cent increase, versus a 0.75-per-cent decrease in the last quarter of 2019.
The Financial Consumer Agency of Canada points out the bulk of home renovation activity is financed by HELOCs, which allow homeowners to borrow money up to 65 per cent of the value of a home and pay only monthly interest costs.
Although interest rates are low now, HELOC costs will rise each time the Bank of Canada increases interest rates. The central bank has hinted the rates may remain low until 2023, but things can change quickly should inflationary pressures start to build up sooner as the economy recovers.
“The way to plan for the likelihood of higher interest rates is to assume rates will rise and to update your financial plan projections accordingly,” says Rona Birenbaum, founder and certified financial planner at Caring for Clients, a fee-for-service financial planning firm in Toronto. She encourages her clients to reduce debt aggressively so they’ll be in better shape when rates do start to climb.
But for now, there appears to be little regard for the possibility of a rate rise among Canadians who have already spent between $5,000 and $20,000 on home renovations since the start of the pandemic, according to a report by HomeStars Canada, an online marketplace connecting homeowners with home service professionals.
Home renos and the HELOC tap
The ideal way to fund a home renovation is to save for it ahead of time, says Ms. Birenbaum. However, given the high cost of reno projects – such as a new kitchen or digging out a basement – some households often need to borrow money.
In the absence of savings, HELOCs are a good way to borrow because they carry very low rates, when compared with unsecured borrowing. Most HELOCs have variable interest rates which are tied to the prime interest rate, which is currently sitting at 2.45 per cent. HELOCs at the big banks are around 2.95 per cent these days.
Regardless of interest rates, a HELOC can be a leaky bucket because renovations often run over time and over budget, Ms. Birenbaum cautions. “If the borrowed amount is not sufficient to finish the job, borrowing more is the only option without a savings buffer,” she says.
The way HELOCs are structured allows Canadians to borrow large amounts of money without having to make payments on the principal, thus making it easy to accumulate and not pay down debt. Given that households were already carrying large amounts of debt before COVID threw the economy and job market into a tailspin, HELOCs should be used with caution.
Avoid the purgatory of perma-debt
To make sure that your HELOC doesn’t become long-term debt, pay more than just the interest portion. “The minimum payment is interest only, [but be sure to] assign a comfortable payment in excess of the minimum payment, which will cause the debt to shrink on a monthly basis,” Mr. Butler says.
If the plan is to pay it off in five years, divide the loan amount by 60 months to determine a monthly allocation, “so that you don’t end up with the same amortization as your house,” he says.
Don’t treat your home as an ATM, under any circumstances, says Melanna Giannakis, a branch manager with Meridian Credit Union. “Refrain from using a HELOC to meet daily and routine expenses or to live beyond your means.” She warns “borrowers can find themselves in a debt spiral, required to [use] more home equity to stay current on their mortgage, and on the home equity they have already used.”
To mitigate the risk of wealth erosion and a tenacious debt, it is paramount to have a realistic debt reduction plan before you take on the debt. “Given such low interest rates, some borrowers are relying on home equity appreciation to more than cover the interest cost of the additional debt,” says Ms. Birenbaum. “That may be fine over the short-term, but is a poor long-term plan.”