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A Home Equity Loan (also known as Second Mortgage) is essentially another loan separate from your original mortgage with a lien on property in second position. A lien is the right to possess and seize property under circumstances explained in your mortgage documents. In general terms, your lender has the right to your property if you fail to keep up with loan payments. In a second mortgage you can borrow up to 80% of the appraised value of your home, less the balance on your first mortgage. Source: https://www.canada.ca/en/financial-consumer-agency/services/mortgages/borrow-home-equity.html

Certain types of loans (i.e. student loans and auto loans) allow you to use money from loan for a specific purpose, whereas you can use the money from second mortgage at your discretion. This is advantageous as it allows you to have access to capital in desperate times. Additionally, most second mortgage lenders offer interest rates significantly lower than credit cards. Considering the fact that the economy has been shaken by the COVID-19 induced closures it might be prudent to consolidate your credit with one monthly payment at a lower interest rate.

A recent Covid-19 Impact Poll commissioned by Toronto-Dominion Bank (TD) highlights the financial impact COVID-19 has had on Canada and certain segments of population.

  • Young adults under 34 and those from “Diverse communities” (i.e. People of Colour (BIPOC) and Indigenous groups) have been hit the hardest by COVID-19. These groups are the most likely to experience financial hardship, a reduction in income and job losses.
  • 20 percent of the general population expect to be late paying their mortgage or rent as a result of Covid-19, compared to 27 per cent for individuals with disabilities
  • The TD survey showed that 66 percent of Canadian respondents aged 18-34 experienced unemployment or reduction in work hours. In comparison, 38 percent of Canadians aged 55+ reported experiencing or anticipate experiencing unemployment or a reduction in income. Source for above: http://td.mediaroom.com/2020-07-09-Young-Canadians-and-Diverse-Communities-Among-the-Hardest-Hit-Financially-by-COVID-19-TD-Survey-Shows

Lenders offer lower rates on a second mortgage or a mortgage refinance than credit cards because there’s less risk. This is because lenders have a lien on your home meaning if you don’t pay the lender has a right to your property. The chart below shows how much it would cost to burrow $40,000 on a second mortgage with a 10% interest rate and amortized over two years with two-year term.

Number of Payments

24

Mortgage Payment

1842.07

Prepayment

0

Principal Payments

$40,000

Interest Payments

$4,209.6

Total Cost

$44,209.6

Source for Calculation: https://itools-ioutils.fcac-acfc.gc.ca/MC-CH/MCCalc-CHCalc-eng.aspx

In comparison, the chart below shows how much interest it would cost if you had a $40,000 balance on credit card with 20% interest and you cannot afford to make monthly payments in full.

Source for Calculation: https://itools-ioutils.fcac-acfc.gc.ca/CCPC-CPCC/CCPC-CPCC-eng.aspx

Category

If you only make Minimum Payment

If you make Minimum Payment + $800

Balance

$40,000

$40,000

Your monthly payment

3% of the balance

3% of the balance +$100

Total monthly payment

$1200

$2000

Annual Interest Rate

20%

20%

Time to zero balance

33 years and 10 months

3 years and 3 months

Total Interest paid

$49,740.60

$9,064.28

This illustrates how costly high interest credit cards can be if you only make minimum payments or pay less than total balance owing.

The downside to a second mortgage is that you will have two monthly mortgage payments. It can be a challenge to keep up with payments especially if your living paycheck to paycheck. It is also critical you avoid accumulating more debt that you cannot pay back, especially high interest debt. This is because you will have to pay the new debt back with interest in addition to making two monthly mortgage payments.

A mortgage refinance could potentially be cheaper than a second mortgage depending on your credit history, mortgage interest rate and how long you intend to live in home. It also has the benefit of requiring you to make only one monthly mortgage payment. In essence, you should ask your financial institution if your eligible for refinance and compare with cost of taking out second mortgage.

Another option is a Home Equity Line of Credit (HELOC) for individuals who have good credit and more than 20% equity in home. In Canada, an individuals HELOC cannot exceed 65% of home’s value or purchase price and functions as a revolving line of credit. Source: https://www.canada.ca/en/financial-consumer-agency/services/mortgages/home-equity-line-credit.html  An individual can withdraw funds as needed and doesn’t pay interest until he or she withdraws funds.

This option could potentially be cheaper than other financing options although is not ideal for credit card debt. The reason being is a HELOC is useful for home-improvements or unexpected financial emergencies where you do not know exact cost. In order to be successful in tackling credit card debt you need to be aware of the specific dollar amount you owe in principal and interest. Unlike with a traditional line of credit or credit card, if you use your HELOC to fund an unsustainable lifestyle it can cause you to lose home upon default.

Conclusion

The Covid-19 pandemic has taken a toll on the Canadian economy. Many individuals acquired debt at unfavourable interest rates or have not been making credit card payments in full. The idea of using your home as security to pay down high-interest credit card debt may seem irrational. However, it can be a useful tool to clear your debt and improve your financial outlook over time. Especially, if you have been only been making minimum monthly payments on credit cards. To be successful, it is imperative that you not acquire new high interest debt as this can make your money problems worse.

Need some guidance on how to make the equity in your home work best for you?  You can call Prudent Financial Services at 1-888-852-7647 or visit www.prudentfinancial.net