A line of credit offers the most flexible access to finance you could hope for – but with flexibility comes responsibility, and you need to very disciplined to make it work. So just what is a line of credit and who is it suitable for?
What is a line of credit?
A line of credit (LOC) is also commonly referred to as an evergreen loan, because it doesn’t have a set term. By comparison, a standard principal and interest mortgage might have a loan term of 25 years, whereas a line of credit can exist indefinitely.
Basically, it’s like having a giant credit card, with interest only payable on the outstanding balance of your loan, rather than your entire credit limit. If your LOC limit is $250,000 but your balance is just $50,000, then interest is only payable on $50,000. In other words, you only pay for what you use.
What can you use it for?
A LOC provides you with flexible access to funding that you can use for a range of investments and purchases, subject to the bank’s approval. For instance, you might use $30,000 to invest in shares, $25,000 to renovate your kitchen and another $45,000 as a deposit on an investment property.
When are payments due?
You can make payments whenever you like, but usually no set repayments are due unless you reach your credit limit. Instead, the lender generally allows you capitalise the interest until you reach your credit limit.
For example, if you have a $250,000 LOC at 7.5%, with an outstanding balance of $50,000, the amount of interest payable would be $3,750 per year ($50,000 @ 7.5%), or $315 per month.
Rather than making a monthly payment, the interest amount is added to your balance, and the following month your interest payment will be calculated according to your new balance ($50,315).
After 12 months, if you make no payments on the loan, you’ll owe roughly $54,000 instead of $50,000. This is a great tool for freeing up cash flow, but it does mean that you’ll effectively be paying interest on your interest – so the bank ends up the real winner.
However, you may be able to save money by depositing all of your funds (such as your salary) into your LOC each month, so that the amount of interest payable is lower. For instance, if you have your monthly wage of $4,000 deposited into your LOC account, you’ll only pay interest on $46,000 until the date that you withdraw any cash.
What’s the catch?
On the surface, a line of credit may seem like the best thing since sliced bread – but be warned, it takes a lot of restraint to avoid mismanaging your loan.
Consider this for a moment: how good are you at managing your credit card bill? Do you pay the full balance every month, and what is your balance in comparison to your credit limit?
A LOC is like having a credit card with a much, much larger credit limit, so the temptation to splurge can be overwhelming. As a result, these types of products only make sense if you are extremely disciplined in managing your every day finances.