A line of credit allows you to draw down on the equity you’ve built in your home. As such, having a line of credit is similar to having a large bank balance at your disposal. The only difference is that you need to pay interest on every dollar you spend from that balance.
You’ll have a borrowing limit, which you can use all at once or in bits and pieces. Usually, this limit is set at 80% of the value of your property, though this depends on the lender.
Imagine you have $300,000 as your line of credit. You spend $60,000 on renovations for your home, instead of taking out a new home loan. That means you need to pay interest on the $60,000 you’ve spent. The other $240,000 doesn’t accrue interest until you spend it on something.
You could start making repayments straight away, or you could capitalise your interest. This means you can add your repayments to the money you’ve drawn from the line of credit until you reach its limit.
Let’s come back to our $300,000 example. You’ve drawn down $60,000 and must repay, say, $700 per month. By capitalising this payment onto the amount you’ve already drawn down, you essentially use $60,800 of your credit after the first month. Your lender will then adjust the next month’s repayment accordingly to meet the new amount. So, you may pay $715 on $60,800 during the second month. This will continue, with the payment amounts increasing each month, until you hit your credit limit.
When you hit your credit limit, it’s time to start making actual repayments. As an interest-only type of credit, you build equity in your line of credit when you place funds into the facility.
You have some flexibility with this. You could pay off the entire debt, allowing you full access to your line of credit again. Or, if you can’t afford it all, you could pay a small portion of it. You should remember that your lender will continue charging interest on the leftover debt, however.
You have a lot of flexibility when it comes to managing your repayments, so you can often control their size and frequency. This can make a line of credit a more attractive option than refinancing your home loan. In fact, many lenders refer to lines of credit as “evergreen” loans because there’s no set time limit for your repayments.
Furthermore, the equity you’ve built in your home will rest in your account until you need to use it. As such, a large portion of the credit can sit unused without gaining interest. You still have access to it when you need it, but you don’t have to worry about what this unused money is doing when you don’t use it.
Lines of credit can also help you to build your home’s value without taking out a new home loan. You can borrow money from your line of credit and pay it back at the existing rate. Most borrowers prefer this to taking out a new loan that reflects the higher value of the property upon completion of the renovations.
Lines of credit can come with higher interest rates. Lenders only charge this rate on the money you use, but the interest can come back to bite you if you don’t keep it under control.
Most lenders also charge set fees for use of your line of credit. These differ depending on the lender, with some charging a monthly fee and others an annual fee. You might expect to pay somewhere between $120 and $350 per year, though some lenders charge higher fees.
Furthermore, using the equity you’ve built could mean you take longer to pay your home loan.
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And so we come to the big question. You need to think about your circumstances before you decide if a line of credit will work for you. This is not a home loan feature that you should use for impulse purchases. Instead, it’s all about control. You need to know what you’ve spent and understand exactly how you’re going to make your repayments to take full advantage of a line of credit.
Lines of credit are most useful for those who’ve built a large amount of equity in their homes. This provides you with a pool of money to draw from for other large purchases, such as buying a car. Your line of credit will usually share the same interest rate as your home loan, which is usually lower than the personal loan you may otherwise have used for the purchase.
Furthermore, investors often use their lines of credit to buy shares. When they sell the shares, they place the money back into the line of credit, which builds the equity they have in their homes.
All of this means that lines of credit are for people who can control their finances. As a general rule, you should only take out a line of credit if you know you can put in more than you draw out.
Depending on how you use it, a line of credit can be a benefit or a burden. Before taking one out, you should: