What is a line of credit and how can I use it?
- A line of credit, or a home equity loan, allows you to borrow money using the equity in your property.
- Equity is the value of your home minus any money you owe on it. If your home is worth $500,000 and you owe $200,000 on your mortgage, then your equity is $300,000.
You can take out a line of credit and spend it over time on anything, from home renovations, to a holiday, to a car, or even to fund another property purchase.
How much of my equity can I borrow?
Most lenders will lend you up to 80% of your property’s value, but some will go up to 90% or even 95%.
Interest rate calculation
You only need to repay the amount you actually spend, not the total line of credit that the lender extends to you.
If you had a $120,000 line of credit and you spent $30,000 on a car, you would only pay interest on the $30,000.
How to use a line of credit loan to invest
Investors can buy an investment property by borrowing equity in an existing property. For example, if your property is worth $400,000 and you’ve taken out a mortgage of $250,000, then you have $150,000 worth of equity. This is a substantial amount of money that can be used to fund the purchase of another property if you’re looking to diversify your portfolio.
Here’s a breakdown of the potential costs of a line of credit loan:
Interest charges. The lender charges interest only on what you borrow.
Upfront fees. Many lenders charge an application fee. A valuation fee is quite common too. You may also have to pay a discharge fee when the loan ends.
Ongoing fees. Some lenders charge a small monthly service fee instead of, or sometimes in addition to, the application fee.
With many line of credit home loans, you don’t have to make monthly or regular repayments. This gives you more flexibility. In many cases, you don’t have to make repayments until you reach your credit limit.
Line of credit home loans are often interest only for the first few years, meaning you pay the interest charges now and repay the borrowed amount later.
This keeps your costs down, but if you continue doing this for a long time it could cost you a lot in interest.
The benefits and drawbacks of borrowing home equity
There are many benefits to withdrawing your equity if you need it. But any borrowing situation comes with risks that you need to know about.
Accessible. Line of credit loans are easier to obtain than other types of loans and credit cards.
Flexibility. The funds can be withdrawn easily via cheque or an ATM card linked to the loan. Some lenders provide borrowers with the ability to withdraw funds through an online banking system or a telephone banking system.
Additional repayments. Extra repayments on the loan can be made at any time, which can help reduce the amount of interest paid over the life of the loan.
Low interest rates. One of the most attractive benefits of a line of credit loan is that it often has lower interest rates compared to other products such as personal loans or credit cards.
Difficult to manage. As it’s easy to access the money, and most line of credit loans involve a large amount of money, the borrower needs to be financially disciplined to manage this type of loan.
Security. If the loan isn’t repaid according to the terms of the contract, the lender can take the property as payment.
Equity loss. Your equity is wealth. It’s yours to use as you see fit, but keep in mind that by using it, you’re reducing – hopefully temporarily – the value you have in your house.
No end date. The flexibility of a line of credit can be a bad thing too. If you take a long time to repay what you’ve borrowed it could get expensive.
How to compare and apply for a line of credit
Comparing home equity loans is a little different to comparing traditional mortgages. You need to look at:
Interest rate. The lower your rate, the lower your repayments.
Fees. The fewer the fees, the better.
Borrowing amount. The amount you wish to borrow is an important consideration. Some lenders have fairly low maximum loan amounts, while others could lend you enormous sums of money (provided that you have the equity).
How do I apply for a line of credit equity loan?
If you’re applying for a line of credit, you may need to satisfy the following criteria or supply the following information:
- Name and address for each borrower
- Purchase date and price of your home
- Employment income
- Outstanding balance and monthly payment on current mortgage
- Estimated market value of your home
- Requested loan amount
- Photo ID for all borrowers
How can I minimise the interest I have to pay?
You can save money on the interest payable over the life of your loan by using your income to offset the loan amount. This can be done by depositing your income into the loan account and then withdrawing money as needed to satisfy your living expenses from the line of credit. With this method, the interest on the loan is only calculated on the remaining balance of the account, which will lower your interest charges.
How can I protect my home?
From a lender’s point of view, they have the security of your home in the event that you default on the loan. If your property depreciates in value, you will end up with less equity and you could even end up owing more on the loan than your home is actually worth. This is why it’s a good idea not to borrow or use the full amount of equity available. Always leave a buffer.
How does a line of credit loan compare to a personal loan?
Line of credit loans typically have much lower interest rates than personal loans. If you’re disciplined in paying off your line of credit, you could potentially save thousands of dollars in interest. Let’s look at an example.
Over the course of the personal loan, you would pay $4,117 in interest. With a line of credit rate, you’d pay $1,322.74 in interest. That’s a saving of more than $2,794 over five years.
However, this requires the discipline to repay your line of credit loan in a timely manner. If you ended up letting your line of credit loan stay open for 15 years, you would end up paying $4,234.29 in interest, eclipsing the amount you would have paid on a personal loan.