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Possible downsides behind record increase in home equity lines of credit

Consumers who are considering consolidating their debt into their mortgage or HELOC should first review their spending habits

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Many Canadians have increased their disposable income while exploring the strange new worlds of quarantines and working from home because their access to goods and services has been limited.

As a result, consumers have managed to reduce their higher-interest unsecured loan and credit-card balances, which sounds like a positive change, but it could be that the debt has been covered by a Band-Aid rather than dealing with the underlying problem that caused the debt to accumulate in the first place.

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For example, new home equity lines of credit (HELOCs) rose 56.7 per cent in the second quarter from the same period a year ago, according to an Equifax Canada release. That’s the highest rate in the past decade.

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It would be reasonable to assume that Canadians have been consolidating their high-interest debt into low-interest HELOCs. This makes a lot of sense from a cost-of-borrowing perspective, but this strategy has possible drawbacks if you don’t consider all its ramifications.

Similar to getting a consolidation loan to pay off high-interest debt, moving debt to a HELOC does not eliminate that debt. It has merely reduced the interest rate and required payment to service the debt.

It’s like digging a second hole to fill in the first hole. If spending remains the same, the debtor runs the risk of reaccumulating debt on those very same credit cards that were just paid off. This could result in having double the debt to repay.

That’s why consumers who have or are considering consolidating their debt into their mortgage or a HELOC should first review their spending habits. More often than not, debt accumulates due to overspending.

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Start by tracking what your life actually costs, then update your budget to match. If the end result is a deficit, the probability of using credit to offset the shortfall becomes greater. The borrower could then find themselves struggling to pay a higher mortgage/HELOC payment in a couple of years, and still have to make payments on those reaccumulated high-interest credit cards.

There are also downsides in using your house as security to pay off debt. One is that you could be putting your home at risk if interest rates increase. Mortgage holders with locked-in interest rates are not going to be immediately impacted when interest rates rise, but homeowners with variable rate mortgages or HELOCs will be.

“In 2018 when interest rates went up, we saw a drop in credit-card payments, especially among consumers with a HELOC,” Rebecca Oakes, assistant vice-president of Advanced Analytics at Equifax Canada, said in the news release.

In other words, if interest rates rise, those with variable-rate debt secured to their homes will face increased housing payments, and, as a result, reduced cash flow to manage their other financial obligations.

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Another negative aspect when using HELOC to consolidate debt is that it often just requires interest-only payments. This is fine for short periods of time when income might be reduced, but when sustained over the long term, the mortgagee could find themselves never paying off that HELOC debt.

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Paying the interest only is like renting the debt and prevents full ownership of the house. Nobody wants to get to retirement with a large mortgage against their house or being forced to sell because they can’t afford that debt once they’re living on a lower retirement income.

An alternative is to ask the HELOC lender to “lock in” the interest rate. This makes it more like a fixed mortgage rate that requires a blended payment to cover the interest and reduce the principal each month.

Even if you have already consolidated your debt into your mortgage or HELOC, it’s not too late to ensure your budget is organized so that you reduce your overall debt load and save for the future.

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If the options for dealing with your debt or even improving your money management seem overwhelming, you can reach out to a not-for-profit credit counselling agency to get a free financial review.

But the most important decision you can make is to deal with your debt and its underlying causes now rather than kicking it down the road to a time when your choices will likely be more limited.

Sandra Fry is a Winnipeg-based credit counsellor at Credit Counselling Society, a non-profit organization that has helped Canadians manage debt for almost 25 years.

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