Rising interest rates could spell trouble for home equity loans

When the Bank of Canada raised its key overnight lending rate on Wednesday — the second interest rate hike in two months — the central bank also raised concern over household indebtedness. 

In its news release it said, "Given elevated household indebtedness, close attention will be paid to the sensitivity of the economy to higher interest rates."

That's because each time the bank raises rates, lenders immediately pass them on to borrowers who hold products based on the prime rate, like variable-rate mortgages and home equity lines of credit — HELOCs — and their interest costs go up. 

For the rush of Canadians who have borrowed against the equity in their homes and tapped into a HELOC in recent years, ultra-low interest rates were likely a deciding factor.

"It's been fairly easy for consumers to justify this in their minds," said Scott Hannah, the president of the Credit Counselling Society, which has offices across Canada. "There really is very little motivation to save. It'd be easier to take out a HELOC."

HELOC debt piling up fast

There are about three million active HELOCs across Canada, with an average balance of about $70,000, the Financial Consumer Agency of Canada recently reported.

Hannah says a responsible way to use a HELOC is to establish a spending limit and a repayment plan. However, he says the concern for some borrowers is that they risk getting into the habit of spending beyond their means.

Unlike with a mortgage, HELOC holders can pay little if any principal each month and instead choose to make smaller interest-only payments. That means balances can build up quickly.

"For a lot of consumers, when you have [a line of credit] and have access to it, it becomes really enticing to use," Hannah said, "In many cases it's for expenses that they should be paying out of their paycheques as opposed to using debt for."

That cycle can be even more difficult to break as interest rates go up and consumers need to divert more of their income to servicing debt.

The warnings keep coming

According to a recent report by the Parliamentary Budget Office, as the Bank of Canada raises interest rates to more historically normal levels — it projects around 3 per cent by mid-2020 — Canadians will have to pay more than ever to service their debt.

Canadians currently use 14.2 per cent of their after-tax income to make principal and interest payments on their debt. The PBO projects that could rise to 16.3 per cent, passing the previous high of 14.9 per cent in 2007.

"There comes a point that consumers cannot take it anymore and then they default on their debt and default on their mortgages and then you have a housing crash," said economist Krishen Rangasamy with National Bank.

While interest rates are still very low, Rangasamy says that if the Bank of Canada is too aggressive with future hikes, borrowers could get into trouble if they keep dipping into the equity of their homes.

"You would ideally want Canadians to have a lot of equity in their homes," said Rangasamy, "because it reduces odds that you actually default on your mortgage."

Watch the Bank of Canada

Many analysts agree that raising interest rates could help to discourage Canadians from taking on even more debt.

Equifax Canada says non-mortgage debt rose to the equivalent of $22,595 per person in the second quarter, up 3.3 per cent over the past year.

"Why not start to address those risks right now when the economy can handle it?" said Rangasamy, "What's the alternative? Do you let consumer credit to keep rising to unsustainable levels?"