Credit line vs. Mortgage – what makes the most sense for you?
Clients often ask us whether they should obtain a mortgage or credit line for their purchase, refinance or renewal. This post should also clarify any lingering questions you may have.
First, let’s clarify what is a mortgage and what is a credit line.
What is a mortgage? The mortgage we will be referring to in this post is a standard long-term loan designed to help you buy or continue to own a house. The payments are blended, meaning each installment is composed of both the principal and the interest. An amortization period is the period of time needed to pay off the debt. Options for this currently go as high as 30 years and rates are based on prescribed terms (i.e., 1, 2, 3, 4, 5, 7, 10 yr). Standard mortgages are either fixed or variable/floating. A Fixed mortgage is when the interest rate is constant for the term. A Variable/floating mortgage is when the interest rate fluctuates throughout the term.
What is a credit line? On the other hand, when we refer to a credit line we are specifically talking about a HELOC (home equity line of credit). A HELOC is a revolving credit loan against your property where installments consist of interest only. Contrary to a standard mortgage, HELOCs are interest-only, are not amortized, do not consist of terms and finally, rates fluctuate according to the prevailing prime rate.
When is a mortgage preferable?
A mortgage makes more sense when there is no immediate intent to repay the money. The majority of people purchasing a home will fall into this category. The primary reason to opt for a mortgage is that the rate will be lower than that of a secured credit line. Mortgages have lower rates because they also carry a prepayment penalty, whereas HELOCs do not. A mortgage prepayment penalty is a fee associated with breaking a mortgage contract before the end of the term. Some reasons to break a mortgage contract include paying a mortgage off faster than originally planned, buying a new home (and selling), or simply wanting to change terms based on current interest rates.
If you do not intend to sell (in the very immediate future), it would be unwise to take on an interest-only product (HELOC) at a high rate. Since you would not be paying any of the principal down with each installment you would end up owing the same amount as you started out with! A HELOC may seem more attractive because it has no prepayment penalty, but this becomes irrelevant after several months of having a mortgage since the interest saved from the comparably lower rate will offset the standard mortgage penalty.
Standard Mortgage
Another benefit of a mortgage is that you will have the option to choose between fixed or variable terms. In other words, if your circumstances happen to change during your mortgage term you can take advantage of conventional mortgage flexibilities without being penalized (such as pre-payments or porting to another property, etc.). So if you have a shift in jobs, income or manage to accumulate some extra money, you can make changes to your mortgage accordingly.
When is a HELOC (credit line) preferable?
A HELOC is a better option if you need more flexibility to borrow and repay the money. This is suitable for you if you have constant short-term money requirements, particularly in the investment realm (such as real estate, equities, bonds, etc.). The downside of a HELOC is the comparably higher interest cost but ultimately this becomes irrelevant due to the inherently flexible nature of a HELOC. With a HELOC you are able to access the money over and over again as long as you continue to pay it off in between.
A standard mortgage, on the other hand, does not allow you to re-advance funds. Once you have paid off your mortgage, the only way to borrow that money again is to refinance your mortgage. (An exception to this is a re-advanceable mortgage).
BE CAREFUL! What we see on a regular basis is that banks love to offer HELOCs to everyone, regardless of whether it is a suitable option for them. Banks do this because it can make it more complicated to leave their bank in the future. Also, it often allows people to get into more debt, which ultimately benefits the bank (in interest paid).