A credit-rating agency is flagging a housing-related risk to the Canadian financial system.
As property values have soared, Canadians have been increasingly securing loans through home equity lines of credit, or HELOCS — which let borrowers tap into the value of their home even if they aren’t finished paying off a mortgage.
This potentially troubling trend poses risks for the financial system as a whole, says DBRS in a new report.
In January, borrowers in Canada owed a whopping $243 billion in HELOC debt, which worked out to 11.3 percent of all household credit. Same time last year, outstanding HELOC balances represented a 10.7 percent share.
DBRS is already concerned about Canadian home prices, especially those in the Toronto and Vancouver areas, and HELOCs only add to financial system vulnerabilities.
The Canada Mortgage and Housing Corporation, a Crown agency, has regularly voiced concern over overvaluation, which occurs when home prices are out of line with fundamentals such as employment conditions, in the country’s highest-priced markets.
If home prices corrected from overvalued levels, consumers with HELOCs could find themselves in a pinch, DBRS notes.
“In the event of a correction, borrowers could find themselves with a debt load that exceeds the value of their home, which is often referred to as negative equity,” writes Robert Colangelo, senior vice president, global financial institutions group, at DBRS.
Financial institutions might change HELOC limits or require principal payments (Canadians with HELOCs today can opt to only pay off interest, which is part of their appeal, and a recent survey suggests a quarter of consumers are doing just that).
Changes financial institutions can make could reduce risks for them, but for consumers? “It may also limit the borrower’s access to credit during a time of financial difficulty. Borrowers with negative equity may therefore have an elevated risk of defaulting,” Colangelo explains.
That homeowners can turn to HELOCs during tough financial is double-edged. On the one hand, as Colangelo makes clear, they can come in handy in a pinch. But they can also mask a borrower’s true financial situation, at least for a time.
A HELOC could be used to make lower-interest payments on consolidated debt, for example, or to cover daily expenses. “As a result, lenders may not observe the initial phases of borrower’s financial distress, if borrowers’ use their HELOC to make regular payments on their other loans,” says Colangelo.