Lines of credit are similar to having a big chequebook, but with interest accruing on the balance. A line of credit, or equity line as they’re sometimes called, is an approved limit of borrowings that you can use a piece-at-a-time or all at once.
Let’s say you have a line of credit for $200,000. This means that you can use up to a total of $200,000 all at once or perhaps invest $50,000 in the share market. If you did the latter, you would only pay interest on $50,000 as the remaining $150,000 would be untouched.
If you were to use a further $70,000 for house renovations, for example, then you would be paying interest calculated on $120,000 ($50,000 for shares + $70,000 for investment) leaving $80,000 to use at a later date if required.
Some lines of credit will allow you to capitalise the interest until you either reach the limit of the line of credit, or a set percentage of the limit. This means that the repayments can be added to the amount already drawn down.
Say you’ve drawn down $75,000of a $200,000 line of credit, and the repayments are $800 per month. In the first month after drawing down the $75,000, a further $800 (your first repayment) will be drawn down from the line of credit. The next repayment will be calculated on $75,800, so it might be $812 Also known as ‘evergreen’ loans because they don’t have a set term, line of credit offers the most flexible option in the market which will be drawn down to cover the repayment, making the total amount drawn down $76,612 and so on, right up to the time that you have drawn down the total limit, or the set percentage (normally 80–90%).
When this occurs you then have to start to service the debt, or pay off a portion of the loan. Lines of credit/equity are by their nature interest-only. Equity is built up by putting funds directly back into the facility. Lines of equity or lines of credit are usually more expensive interest rate-wise, and will often have a monthly, half yearly or annual fee attached to them. This may be from $10 per month to $600 per year, though most are in the $120–350 per year category.
The credit limit is usually set as a percentage of the property’s value, generally around 80%. So if your property is valued at $200,000 the credit limit will be around $160,000. Also, note there are significant differences between products on offer; some work like this for an initial period, say 10 years, then turn into an amortising principal & interest loan.
Should I get a line of credit?
A line of credit can be useful if you have built up a reasonable amount of equity in your home, as you can easily access it to purchase other assets or items. For example, you could draw down on your home equity to fund a new car.
The benefit of this is that you are effectively borrowing for a car at home loan rates. Interest rates on personal loans or car loans are usually significantly higher than home loan interest rates.
Some investors also use a line of credit to invest in the share market. When they sell shares they put the money into the line of credit, reducing the balance and increasing the equity they have in their home, and when they want to purchase shares they draw down on their equity.
Using the equity in your home this way can be an effective form of financing because home loan interest rates are the lowest interest rates many people are offered.
One thing to keep in mind is that if you use the equity you have built up in your home to fund other purchases it is likely to take a lot longer to own your home. This may not necessarily be a bad thing.
If you are using the money for investments such as property, which earn a good return, you are likely to increase your net wealth. Similar to an overdraft account, a line of credit allows you access to additional funds by drawing on the equity value of your home. You may not wish to sell just yet, but if the value of your home has appreciated, and you are in need of some extra cash to finance a home improvement or even an investment property, a line of credit loan may be the answer.
Lines of credit have also been marketed as a tool to help you reduce your mortgage fast by directing income from all sources into your line of credit loan account, and then drawing living expenses as and when required.
Interest on your loan is calculated on the remaining balance in the account, so the longer your income is held, the less interest you will pay on your mortgage. Be warned though: if you have no fiscal restraint you may end up drawing out more than you put in, resulting in higher debt.
You’ll have greater flexibility in managing the size and the timing of your repayments, enabling access to additional funds and even taking your mortgage with you to a new house. Because your entire income stays in your account until you need it, a major portion of your income stays in your loan account longer, and saves you interest.
These products may seem like the best thing since sliced bread, but be warned – most come at a price, and the extra funds you shell out for a loan feature may not actually pay off financially.
As you have virtually unlimited access to your funds, a line of credit is only a sensible choice if you are extremely disciplined in managing your everyday finances. If you will be tempted to use the funds for spur of the moment purchases, a line of credit is probably not for you.