A line of credit has been touted as being the ideal loan product to help you pay off your mortgage as fast as possible. So just how does it work, and can it really help you get ahead with your home loan?
A line of credit (LOC) boasts many attractive features, but it doesn’t suit everyone, explains Kristy Sheppard, Senior Corporate Affairs Manager at Mortgage Choice.
How it works
A line of credit loan is a flexible mortgage arrangement, which works like a credit card with an enormous credit limit.
With a LOC you can secure funding of a certain amount, but you are only required to pay interest on the amount of money that you have spent.
For instance, if your line of credit has a limit of $500,000, and you spend $220,000 purchasing a block of land, you will only be charged interest on $220,000.
How to make it work for you
The most effective way to use a LOC is to have your household income paid into the loan account, so that it reduces the daily interest applied to the loan. If you and your partner earn $6,000 per month between you, with a LOC limit of $500,000 and a current debt of $220,000, you’ll only be charged interest on an amount of $214,000 for every day that your salary remains in your account.
On an average 7% home loan, this equates to around $1.15 per day, or $8 per week. It doesn’t sound like much but it all adds up: once you factor in tax refunds, commissions, work bonuses and any other lump sums you may receive, the savings can be significant.
“Sometimes a line of credit home loan is attached to a credit card, hence the borrower places their income into the loan account to save on daily interest, and the credit card is used to make most purchases,” Sheppard explains.
“If you’re on a decent income, using this credit card for expenses should mean that most of your income stays in the loan until the credit card account is due. This somewhat reduces the balance of the home loan debt for part of the month, which reduces the interest payable on the loan. Your credit card is then repaid each month, using money from the line of credit loan.”
Who it suits
“Line of credit loans can work for borrowers who are disciplined enough to follow strict budgeting, resist impulse spending and keep their home loan top-of-mind,” Sheppard says.
“But, you must be careful to only spend what is budgeted, or the loan balance will not reduce.”
In order to make your LOC work effectively, you must be “extremely cautious with your spending and repayments”, Sheppard says.
“A line of credit can be a great way to pay off a loan in a shorter period of time, for someone who can follow a strict budget for the loan duration. It can also work well for disciplined borrowers who are determined to pay off their home loan quickly, without allowing impulse purchases,” she explains.
“But using a line of credit can be dangerous, because you’re not locked down to repay any principal debt, provided that the level of debt remains under the loan-to-value ratio that you agreed on at the commencement of the loan.”
Sheppard adds, “There is no set term for the loan to be repaid, which means the home loan may not eventually be paid off – and the debt level may actually rise, due to loan interest and charges.”
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