Home truths: The financial product that turned into a $207-billion debt trap

Open this photo in gallery:

Pamela Capraru’s long-term financial plan was overturned by a home renovation that went far over budget.

“It’s really the reno that kind of threw everything into disarray,” said the freelance editor, who lives in Toronto’s Leslieville neighbourhood.

Self-employed after being laid off several times from downsizing magazines, Ms. Capraru, 59, has absorbed three interest-rate increases by the Bank of Canada since July, maintaining her payments on the $70,000 outstanding on her home-equity line of credit, as well as a variable-rate mortgage and $41,000 in credit card debt.

But she doesn’t believe she could cope if interest rates were to spike sharply: “I’d be thinking about selling my house and moving to a smaller community,” she said

With consumer-debt levels soaring in Canada, people like Ms. Capraru are struggling with growing payments as interest rates climb from historic lows – especially people with large outstanding balances on home-equity lines of credit (HELOCs).

In 2017 alone, customers of Canada’s six largest banks borrowed $14.4-billion more on their HELOCs than they repaid, pushing such borrowing to a record $207-billion as of Oct. 31 – up 7.5 per cent from a year earlier, according to a Globe and Mail analysis of the banks’ financial reports.

Spurred by soaring house values, HELOCs – which allow people to borrow against the equity they have in their homes – have become the key household credit source for Canadians, now accounting for 40 per cent of all non-mortgage consumer debt, according to a 2017 report by the Financial Consumer Agency of Canada. Credit cards, by comparison, represent about 15 per cent of non-mortgage debt.

HELOC borrowing isn’t a problem, of course, for people who can afford the monthly interest costs. But unlike loans with fixed rates of interest, HELOC costs go up each time the Bank of Canada raises interest rates because most of these lines of credit are directly linked to the prime lending rates of banks. The result is a population that is increasingly vulnerable to shocks if rates climb quickly.

With the central bank now in rate-raising mode, Laurie Campbell worries that even small rate increases will have an oversized impact on borrowers who are also facing rising mortgage payments. The chief executive officer of Toronto-based Credit Canada Debt Solutions, a not-for-profit agency that provides free financial counselling, says she fears that problems for the most vulnerable borrowers will crystallize this spring as a wave of mortgages come up for renewal. Some of her agency’s clients plan to list their houses to repay debts, and she is concerned they will not get the price they need in the soft Toronto market.

“It makes me feel a little bit nauseous – I just think we’re in a really dangerous situation right now.”

Climbing balances

HELOC use began growing sharply in the early 2000s as banks increasingly provided the credit lines as a standard add-on to new mortgages, discovering a consumer appetite for a product with lower interest rates than credit cards and a far larger borrowing limit. From a lender’s perspective, they are virtually risk-free because the borrowing is fully secured against a home.

The Financial Consumer Agency of Canada (FCAC), which is responsible for promoting financial awareness, estimates that 80 per cent of HELOCs in Canada are “readvanceable,” meaning the borrowing limit automatically grows as customers make mortgage payments, increasing the amount of equity they have in their home. Combined with soaring home prices, borrowing can increase for years without hitting the sort of limit that is typical with credit cards.

Between 2000 and 2010, outstanding balances in Canada climbed by an average annualized rate of 20 per cent, according to the FCAC – from $35-billion to about $186-billion.

The borrowing slowed sharply after the recession in 2009, but outstanding balances rose 3.1 per cent in 2016 and spiked again in 2017, up 7.5 per cent, according to data from the financial reports of the Big Six banks. During the two years ended Oct. 31, Canadians increased their HELOC debt by more than $10-billion.

James Laird, president of Toronto-based mortgage brokerage CanWise Financial, said one reason for the spike in 2017 may have been the federal government’s mortgage rule changes introduced in late 2016, which prohibited banks from obtaining bulk insurance from mortgage insurers such as Canada Mortgage and Housing Corp. for their portfolios of refinanced mortgages.

Mortgage refinancing allows borrowers to increase the size of an existing mortgage to extract equity from a home, but HELOCs have become a somewhat more appealing alternative because lenders have raised interest rates for refinancings as a response to the mortgage rule change.

“If it doesn’t cost you too much more to keep the flexibility of having as much money in or out of the line of credit whenever you want, you’d prefer that for sure,” Mr. Laird said.

Rising home values in Vancouver and Toronto have also spurred HELOC growth by quickly giving Canadians more equity to borrow against. And the high cost of housing in both cities has left people juggling larger mortgage payments, creating more incentive to dip into HELOCs to cover day-to-day living expenses.

Canadian Imperial Bank of Commerce reported that 57 per cent of the growth in clients’ HELOC balances in 2017 came from the Greater Toronto Area, with a further 14 per cent coming from Greater Vancouver.

Mr. Laird also believes that part of the growth is the result of lenders increasingly advertising them for a much wider range of purposes than their traditional use for home renovations and repairs. They are pitched as a good cash source for the self-employed with variable incomes and a good way to finance a small business. Growing numbers of people use their credit lines to make down payments on investment properties or to help their children with down payments.

Mr. Laird says he is also seeing seniors use them as a cheaper alternative to a reverse mortgage, allowing them to draw money each month from their home equity to fund living costs. The balance on a HELOC will eventually be repaid when the house is sold, often after the borrower has died.

“Over all with the equity being there, people are finding many uses for it,” he said.

Wealth erosion

Patricia Irwin, a resident of Vernon, B.C., almost lost her house because of her HELOC borrowing.

The credit line was initially “wonderful,” allowing her to borrow as needed to cover monthly shortfalls without taking out a large fixed loan. But within a couple of years she was juggling two lines of credit, drowning in debt and paying only the interest to keep up with her mortgage payments.

“I was very close to losing my house. I could feel my nose on the pavement,” she said.

Ms. Irwin, 62, turned to credit counselling for help and developed a repayment plan, which will see her pay off the last of her non-mortgage debt this year. Instead of relying on a line of credit to stabilize her income or pay for emergency costs, she is building up savings to keep on hand for the unexpected.

The broader impacts of HELOC growth are becoming clearer as Canada moves through the second decade since the popularity of the products took off.

Experts say these lines of credit are contributing to debt persistence by allowing homeowners to borrow large amounts without having to make payments on the principal. Canadians can borrow as much as 65 per cent of the equity in their house while paying only the interest costs and can borrow as much as 80 per cent if they make scheduled principal repayments on the portion above 65 per cent.

Unlike traditional mortgages, which force even the worst savers to accumulate wealth in their house before retiring, HELOCs can lead to wealth erosion, ultimately allowing people to retire with large debts rather than large amounts of home equity.

“The days of being able to have a ‘burn-the-mortgage’ party aren’t going to happen as fast or as often if individuals continue to have [HELOC] debt on their homes,” said Brigitte Goulard, deputy commissioner of the FCAC.

“A HELOC makes it so that you can pretty much use your house as an ATM and use the equity you have for trips or clothes or other expenses that do not improve the value of your home.”

Only about 20 per cent of Canadian homeowners have a HELOC, but those who have one tend to use it, according to data from Mortgage Professionals Canada, an industry association for the mortgage sector. The organization estimated in a 2016 report that just 23 per cent of households with a HELOC had no outstanding balance, while 77 per cent were using their line of credit.

There are about three million HELOC accounts in Canada with an average outstanding balance of $70,000, the FCAC said. The average mortgage in Canada is $192,000, according to Mortgage Professionals Canada.

Scott Hannah, chief executive of the Credit Counselling Society in the Vancouver suburb of New Westminster, has worked with many homeowners who find it hard to resist the temptation of HELOCs to fund lifestyles they cannot truly afford.

“With HELOCs, they are so convenient that people who aren’t managing effectively are the ones who can be hurt the most, because every time they’re short, they just dip into their HELOC,” he said.

Because the required monthly payment is so low when borrowers only pay interest, Mr. Hannah said some people don’t fully grasp that they’re living beyond their means until they hit their borrowing limit. A balance of $100,000 at 5-per-cent interest, for example, costs $417 a month when the borrower is paying interest only, giving them a false sense that their debt is manageable.

Mr. Hannah had a client who had been retired for three years and was proud of having no mortgage. But when questioned further, he said he owed $150,000 on a HELOC.

“I said to him that whether it’s a mortgage or a HELOC, it’s still debt,” Mr. Hannah said.

Rising rate pressure

Open this photo in gallery:

The interest-rate shock for HELOC borrowers is coming at a time when many Canadians are also facing the prospect of renewing their mortgages at a higher interest rate.

The Baldwin family of Vancouver has two fixed-rate mortgages coming up for renewal, while also carrying a large HELOC balance used to help finance the construction of a new house.

Patrick Baldwin, a 36-year-old web programmer, and his 34-year-old wife, Sarah, a high-school teacher, are closely monitoring interest rates while deciding what to do when their first mortgage renewal comes up this month and their second one comes due in June. The Baldwins paid as little as 2.29 per cent in the past and are now considering locking in for a three-year term at about 3.2 per cent on total mortgage debt of about $1.2-million.

“We’re hoping that interest rates might come down in three years,” said Mr. Baldwin, whose parents made a large contribution toward a down payment. “With my wife being pregnant and all the mounting bills, it’s stressful for us.”

The Baldwins entered the housing market in 2008 by buying a suburban condo and feel fortunate to have scooped up a run-down property in mid-2016 on Vancouver’s east side for $1.45-million – a bargain in a city where the price for detached houses sold last year averaged $2.64-million.

The Bank of Canada says 47 per cent of mortgages were up for renewal during the one-year period that began July 31, 2017, including variable-rate mortgages. CIBC World Markets Inc. estimates that variable-rate mortgages comprised almost 24 per cent of the total market last year.

“Rates are going up. Some people are preparing for that, but others aren’t,” Mr. Hannah said. “With some people, it may mean they have to downsize their expenses or lifestyle.”

In early March, The Globe and Mail conducted an online survey of 1,521 readers, asking them about their HELOCs and mortgages. Of the 918 respondents with mortgages up for renewal within the next year, a majority were worried about rising interest rates. Asked to rank their concern on a scale of 1 to 5, 58 per cent said 4 or 5.

Economists are forecasting one or two more rate hikes this year, which would boost mortgage rates by as much as half a percentage point. For customers with five-year fixed-rate mortgages, interest rates at chartered banks are currently above 3.5 per cent, compared with an average of slightly less than 3 per cent in 2013, according to National Bank.

​ “I’m concerned generally about rates and I’m watching, but I think it’s going to be moderate in impact, so I’m not freaking out about it,” said Eric Carlson, CEO of Vancouver-based developer Anthem Properties Group Ltd.

“If rates went up by two or three full percentage points, I would really be concerned. A couple of 25-basis-point increments slowly over time? You can adjust to that.”

Benjamin Tal, deputy chief economist at CIBC World Markets, said consumers are already making moves to insulate themselves before rates rise further. “You will see more fixed and fewer variable mortgages – when you have interest rates rising, people do that during a transition period,” he said.

Mr. Tal, however, believes that tougher new mortgage stress-test rules will force some consumers turned down by chartered banks to borrow at higher rates from credit unions or alternative lenders, adding to the interest-rate pressure.

“It’s already happening,” he said.

Tamping down house values

The federal government has made several policy changes in the past decade to curb the systemic risk of excessive HELOC growth. In 2011, for example, Ottawa forbade banks from buying bulk portfolio insurance to back HELOC loans and, in 2012, regulators lowered the amount people can borrow on such lines of credit to 65 per cent of the equity in the home. Both measures appeared to slow the growth in borrowing, but the reforms were overwhelmed by rising home values, which gave homeowners far more equity to borrow against.

Ms. Goulard at the FCAC believes one solution is to arm consumers with more information about how HELOCs work and a clearer understanding of the risks. The agency plans to survey consumers and hopes to work with banks to improve the explanatory information they provide to customers.

The greatest risk of the debt binge could come if Canada were to see a significant housing correction, with prices falling sharply in major markets such as Toronto. A steep drop could not only leave mortgages under water, it could have HELOC borrowers scrambling to make principal payments or cover their debts when they sell their homes.

Ms. Goulard says consumers need to have a repayment strategy. She says the vast majority of people don’t plan to pay off their HELOCs until they sell their homes, which can be risky if prices fall before they sell.

“It certainly seems to be the case that most people believe they will pay off their HELOC when they sell their home, but I’d suggest you be careful that the value of your home isn’t lower than what you owe on it at that time,” she said.

In extreme circumstances, banks can reduce the size of the credit line or insist borrowers make principal payments if outstanding balances exceed the 65-per-cent cap, said Charles Gibney, a research and policy officer at the FCAC.

HELOCs are demand loans that can be adjusted at a bank’s discretion if house values fall, although Mr. Gibney says lenders don’t rush to call loans and push borrowers into insolvency because they can end up taking a loss.

National Bank economist Marc Pinsonneault believes HELOC growth could be reduced by slowing growth in home prices in major cities such as Toronto and Vancouver. The new mortgage stress-test rules and recent real estate tax measures announced by the B.C. government, for example, are expected to slow price growth, which will reduce growth in borrowing against home equity.

“It’s generally expected that house prices in Canada cannot continue to grow forever, so maybe the space for new growth for HELOCs will diminish over time, over the next decade,” he said.

If interest rates rise sharply, Mr. Pinsonneault says, many people will be motivated to pay off some of their outstanding HELOC balances.

“If people are forced to pay what they consider an excessive interest-rate bite, why wouldn’t they choose to pay back some of the outstanding balances?”

However, Ms. Campbell at Credit Canada Debt Solutions is concerned about the impact on consumers in the meantime.

Some homeowners are using money that could go to retirement savings to make large interest payments on their HELOCs instead. Paying interest on debt means that money is not helping them accumulate home equity or save – instead, they're just renting their homes from the bank, she argues.

“I fear we’re going to have a generation of people who really are not going to be able to retire when they want because of large mortgage debt and HELOCs,” she said. “People have this mentality that their home will be their nest egg when they retire. Well, that nest egg is dwindling with all these HELOCs, so they may not have much of a nest egg.”

How Canadians are using their HELOCs

Homeowners are using home-equity lines of credit for an expanding variety of purposes, making the low-interest borrowing lines the primary financing source for everything from vacations to stock market investing.

An online survey of 1,521 readers conducted by The Globe and Mail in early March found that most HELOC borrowers now use them for multiple purposes, going far beyond their traditional use for home renovations.

While 32 per cent of respondents with a HELOC said they have used it for renovations or repairs, many also said they are using them for personal expenses, debt consolidation, vehicle purchases, retirement investing or financing small businesses.

Sixty-two per cent of respondents said they have a HELOC, and 65 per cent of those said they currently have an outstanding balance.

The survey found 23 per cent of people with an outstanding balance said they used their line of credit for living expenses, including bills, vacations and education costs. Seven per cent said they used their HELOC to buy a vehicle, and 16 per cent said they used it to pay off or consolidate other debts, including credit cards, which typically have far higher interest rates.

Debt counsellors say they are most concerned about people using HELOCs for day-to-day expenses if they are running up debt to pay for things they cannot afford.

Laurie Campbell, chief executive officer of Toronto-based Credit Canada Debt Solutions, has seen clients pay off $30,000 to $50,000 in credit card debt by consolidating it with a HELOC – only to go out and use the credit cards again.

“I think these people are financing a lifestyle they can’t afford,” she said. “It is through day-to-day purchases. They might be eating out or spending money in other areas when they think they have the money, but they really don’t.”

Thirteen per cent of Globe survey respondents with an outstanding HELOC balance said they used it to help finance the purchase of another property, including a vacation home, and 18 per cent said they used the money for other investing purposes.

Five per cent are using it as an alternative borrowing source to pay their primary home mortgage, and 2 per cent said they used it to cover expenses for their businesses. (The percentages do not add up to 100 because respondents could list multiple uses.)

Of those carrying a HELOC balance, 55 per cent said the balance has increased in the past year, and 39 per cent said they have only paid interest in the past year.

The median amount outstanding was $60,000, respondents said.

James Laird, president of Toronto-based mortgage broker firm CanWise Financial, said the most concerning trend is the growth in people using lines of credit for purchases that add no long-term value to their household balance sheet.

“I think the concern would be that if this debt is being frittered away on not-intelligent investments, we should be concerned as a country,” he said, noting there is no bank approval needed for how the borrowed money is used.

“It’s just sitting there, and you can just walk into the Ferrari dealership if you want to – no one tracks that.”