Ross Taylor & Associates

How to become debt free using your home equity and refinancing

According to an Ipsos poll conducted in December 2017 for Global news, the average Canadian owes about $8,539 in consumer debt (excluding mortgage). The poll also revealed some other staggering figures: 12% of Canadians reported debts above $25,000!

Although nearly half of the respondents reported negligible debt, it's disconcerting to note that those who've managed to chalk up their debt actually owe an insane amount of money.

In fact, the dominant demographic that lives under this burden are aged 35-54, and they reported their average debt to be above $10,000.

With rising consumer debt levels and increasing interest rates, having an unfavorable balance on your card can adversely affect your finances.

Let's see how leveragingyour equity and refinancing your mortgage can help you go debt free.

What is equity?

To put it simply, equity means ownership. In accounting, equity or owner's equity is calculated as the difference between the value of an asset and the liabilities on that asset. To illustrate with a simple equation,
Equity = Asset - Liabilities.

Say, if your house is worth $500,000 (value of your asset) and you've managed to pay off half of that, you still have $250,000 as your liability.

So your owner's equity in this case is $500,00-$250,000 = the remaining $250,000.

Here's how you can pay off your high interest debts by leverage your home equity

Ratehub reports that according to the Canadian Association of Mortgage Professionals, 10% of Canadian mortgage owners accessed about $49,000 of equity from their homes in 2017.

In Canada, you can access a maximum of 80% of the value of your home minus your outstanding mortgage balance.
Let's assume your home is worth $500,000 and you've paid off $200,000. So the outstanding mortgage is $500,000-$200,000 = $300,000.

Based on the above information, you can calculate the maximum available equity in the following way.
Step 1: Calculate your maximum refinance value.

$500,000 x 80% = $400,000
Step 2. Derive your maximum available equity
$400,000 - $300,000 = $100,000

You can take a home equity loan to be one step closer to being debt free. But here's the rub: in a home equity loan, your house is the collateral and you run the risk of losing your house if you default on payments.

Refinancing your mortgage may be the next best step

Although refinancing would mean breaking your mortgage term and attracting a penalty, you can still pay off your debts with the savings from opting for a new loan at a lower interest rate.

Let's take the same home value as above ($500,000) and assume that you're now opting for a lower mortgage rate of 4.5% post refinancing and you're two years into a five-year term at a fixed rate of 6%. Also, let's assume you've paid off $200,000 in the two years.

Step 1. Calculate the interest savings

6% (existing mortgage rate) - 4.5% (new mortgage rate) = 2.5% interest rate differential (IRD)
2.5% IRD x $300,00 (outstanding mortgage) x 3 remaining mortgage term = $22,500 interest savings at the lower rate
A major cost in refinancing is the breakage penalty. In case of a fixed rate mortgage, you will pay end up paying either the three months' interest or the interest rate differential, whichever is greater. However, on a variable mortgage, you will only have to pay three months’ interest.

Since our example is a fixed-rate interest, we shall calculate both three months' interest as well as the interest to determine which is greater.

Step 2: Calculate three months' interest

6% (existing mortgage rate) x $300,000 (outstanding mortgage) x 3 months ÷ 12 months = $4,500
Step 3: Calculate the IRD
(6% - 4.5%) ÷ 12 months = 0.12%
0.12% x $300,000 (outstanding mortgage) x remaining 36 months = $12,960
In this case, the IRD is a bigger penalty and will be used to calculate the refinance savings.
So, $22,500 - $12,960 = $9540 is your savings
You can use these savings to pave your way to a debt free life.

Click this to watch a video