With the rapid rise in the real estate market, you may now find yourself with significant equity in your home, yet you are also carrying high interest unsecured debt. On paper you have equity in your home, but you may still be “insolvent”, meaning you can’t pay your bills as they come due. You may be able to borrow money from your home equity to consolidate credit cards and other debt into one, lower, monthly payment. But what happens if you can’t access that equity or the cost is too high? Is a 100% consumer proposal a better option?
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Home equity debt consolidation
There are four ways to use your home equity to pay off debt:
- Refinancing is where you approach your current mortgage lender and ask to roll your consumer debt into your first mortgage.
- A home equity line of credit, HELOC, is a secured line of credit where the bank gives you a certain fixed credit limit you can draw money against to pay down unsecured debt.
- A second mortgage, or home equity loan, is a personal loan secured against your house with an amortization like any mortgage. With a second mortgage, you receive a lump sum of money to be used to pay off outstanding credit card debts, payday loans, overdue bills and other debts.
- A consumer proposal is a program that allows Canadians who are not able to repay their debts as they come due to make a repayment proposal to their creditors.
Below I’ll explain how each debt consolidation option works and some pros and cons of each solution.
Refinancing your mortgage
The maximum amount you can refinance with a first mortgage is 80% of the appraised value of your home. When you refinance to pay down consumer debt, you replace your current mortgage with a new mortgage with new terms. Your lender typically gives you a cash lump sum which you use to pay off your credit card debt.
The advantage will be one monthly payment; however, you need to be sure that refinancing will improve your cash flow. A higher principal balance will likely translate into a higher monthly mortgage payment. However, this can be offset by not having to make payments on your credit cards. Those payments may not be lower than what you are paying today, especially if you were only making minimum payments.
If interest rates have fallen since you signed your last mortgage, you may save money there, however, you may also be charged a penalty for breaking your existing mortgage contract early and possibly appraisal fees and legal costs.
Your monthly payments will be based on the amortization period you choose. A longer term means lower payments, but it also means paying more interest over time.
Home equity line of credit
To avoid pre-payment penalties with changing the terms of your existing mortgage, you can consider consolidating debt with a home equity line of credit. A HELOC is a stand-alone line of credit secured against your home’s equity.
The maximum loan-to-value ratio for a line of credit is 65% of your home’s value. This means you need much more equity in your home to qualify for a home equity line of credit.
A home equity line has the advantage of providing a revolving line. This means you can borrow and repay as often as you need, and the credit limit remains in place as long as you are making your minimum payments.
Home equity lines of credit charge variable interest rates. The best borrowers will qualify for rates just above prime; however, if you have bad credit, you be charged a higher mortgage rate, assuming you are eligible. Home equity loan rates are usually higher than first mortgage rates but lower than those charged on credit cards.
The advantage of a home equity line is low mandatory monthly payments. Many HELOCs require only interest payments or interest plus 1% or 2% of the principal balance. This is likely much better than payments you are making on your current debt; however, if all you are paying is interest, you are not paying down your debt.
Second mortgage home equity loan
If you can’t refinance with your current lender, another option is to get a second mortgage using your home’s equity. You can borrow up to 90% of the market value of your home with a second mortgage. However, if you are using a higher-ratio mortgage and because second mortgages sit behind the first mortgage lender when it comes to payout in the event of default, interest rates are much higher on second mortgages. Even a traditional lender will charge between 3% and 10%, depending on your credit.
The advantage of a second mortgage is no breakage penalties as with refinancing, but higher interest rates can offset these savings.
Can you qualify for a home equity loan?
You must meet all required lender qualifications to be approved for any home equity loan:
- Your loan-to-value ratio must not be above 80% for a first mortgage, 65% for a HELOC, and up to 90% for a second mortgage or private mortgage.
- Your debt service ratios must be within allowable limits. Most lenders require your housing costs plus other debt payments as a percentage of your gross income to be no more than 43%.
- You must meet the mortgage stress test to prove you can afford the payments even if interest rates rise.
- You will need to have a reasonably good credit score. The lower your credit score, the less options you have and the higher your interest rate will be.
Second-tier lenders can be expensive
If you can’t access your equity through a traditional mortgage or lender, you could consider a second-tier mortgage lender. There is a vast secondary mortgage market in Canada, funded by private investors. However, second-tier private mortgages can be very expensive. You may discover that the monthly payment remains so high that it does not solve your cash flow problems. If you can’t afford to keep up with the payments over the long run, you could end up defaulting on your new second mortgage. This will only make your situation worse, further dragging down your credit score and potentially risking your home to foreclosure.
What is a 100% consumer proposal?
We are increasingly receiving calls from people in this exact scenario. Caught between a rock and a hard place, they don’t want to lose their home, yet they can’t access their equity through a mortgage lender to deal with their debt. In these cases, we can present a consumer proposal as a viable alternative.
A consumer proposal is not a loan. It is a negotiated repayment plan with your creditors.
In this type of situation, your consumer proposal won’t be a ‘deal’. You won’t be able to settle your debts for less than you owe because you have enough equity in your home to cover all your debts. You just can’t get at this equity cost-effectively.
What you can do is make an offer through a proposal to repay 100% of your debts over up to 5 years. Certain aggressive creditors, if they make up the majority of your debts, may also ask you to pay a little more to cover government filing levies, credit counselling and trustee fees deducted from their payments. However, the proposal once agreed to, is interest free.
Let’s look at a typical example.
Jonas owes $50,000 in credit card debts, a payday loan and some taxes owing to the Canada Revenue Agency. He has $65,000 equity in his home but has poor credit, so he cannot qualify for a home equity loan.
Since he has more equity in his home than the total of his unsecured debt, his creditors will expect to get paid in full, so he must propose to pay at least $50,000 to his creditors. With a five-year proposal that works out to $835 a month over 60 months. This is much less than the minimum payments on his unsecured debt which might range from $1,200 to $2,000 depending on the type of debt he carries. Additionally, with a proposal Jonas will be debt free in five years.
If his creditors ask for his proposal to cover trustee fees, he may have to offer more. How much more depends on how much equity you have and your income. the effective cost and total amount of money you pay is still much less than what you would pay with a high-ratio second mortgage.
Refinancing debt through a consumer proposal is not for everyone. It is a good option if:
- You have problems with your credit report due to late debt payments.
- Your unsecured debt plus your current mortgage would exceed 90% of your home equity.
- You have a low credit score which may result in an interest rate so high you are not saving money.
- You do not have enough income or job security to support your monthly mortgage payments.
There are four key advantages of using the equity in your home to make a consumer proposal plan:
- You keep your home
- Payments are interest free
- You pay off consumer debt in five years
- It can be much less costly in the long
If you can’t afford the payments under a consumer proposal, which has a 60-month limit, it is possible to file a Division I proposal to extend the term.
Whether or not this is the right option for you will depend on your specific situation. The important thing is to consider all your options before settling for an expensive home equity consolidation loan.
If you have a good payment history with your mortgage company and your house is worth more than you owe, talk with your mortgage broker to see if you can consolidate your debt using your home equity at a reasonable cost. That could be refinancing your first mortgage or getting a second mortgage or home equity line of credit.
But if the interest rate is too high or you don’t qualify, consider a consumer proposal instead.
For a more detailed look at the cost difference between an interest-free proposal and a second mortgage, book a free consultation with a Licensed Insolvency Trustee today.