Lines of credit, often referred to as equity lines, have proven to be invaluable sources of capital for homeowners who have built up a reasonable amount of equity in their homes. Those owners looking to renovate, build a portfolio of income-generating investment properties or make other major purchases can leverage a line of credit, repaying the money at their home loan’s interest rate. Because home loan rates are far lower than those commonly associated with personal loans or car loans, using the equity in your home can be one of the most effective ways to finance the purchase of vehicles or shares.
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, a line of credit loan may be the answer.
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 much longer to finally 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.
Lines of credit have also been marketed as a tool to help you reduce your mortgage faster 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. Do your research.
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.
How a line of credit works
Part of the beauty of a line of credit is its flexibility. You can use it a piece-at-a-time or all at once.
For an example, assume you have a line of credit worth $200,000. You can use up to a total of $200,000 all at once – maybe to make deposits on a pair of investment properties – or perhaps you’d prefer to invest $50,000 of it into 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.
Let’s assume you’ve drawn down $75,000 of 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. This process will continue until you have drawn down the total limit, or the set percentage of your home’s value.
(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.)
When the limit has been reached, you then have to start servicing the debt or pay off a portion of the loan. Lines of credit/equity are by their nature interest-only, with equity being built up through your 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.
Also known as ‘evergreen’ loans because they don’t have a set term, lines of credit offer homeowners one of the most flexible financing options in the market. But there are significant differences between products on offer; some remain interest only for an initial period, say 10 years, and then turn into an amortising principal & interest loan. Be sure to consult your financial advisers before making any major decision regarding the equity you’ve built up in your home.
This article was originally written in April 2011 and was updated for content and formatting in January 2018
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