Whether you are buying a property and applying for a loan for your home or an investment property the aim is always that the property will increase in value. As your property increases in value the difference between the amount you owe and the amount your property is worth increases and this difference is equity. Normally you can get your hands on the equity in your home when you sell because the sale price goes to pay off your remaining loan and was left is your profit in equity. However with a line of credit equity loan you can access that extra value to further secure your financial position, while enjoying living in a home of your own as well.
Line of Credit Loans
What is a Line of Credit Loan?
Here we have industry experts Carla Baldock | RAMS, Heidi Armstrong | State custodians Mortgage Company, and Neil Manuel | eMoney cover basics on line of credit equity loans
Click here for video transcript:
Carla Baldock: Okay. A line of credit is really a funding line and where a customer is approved a certain loan against a security and they're able to draw on that loan amount at any point in time.
Heidi Armstrong: So the line of credit facility is really all about having a fluctuating balance and no real commitment to paying it off.
Neil Manuel: The benefit of taking out a line of credit loan is if you don't necessarily need all the money that you've applied for immediately, for example, you could take out a $400,000 line of credit loan, but if on settlement you only need $200,000 of that, then you only draw down $200,000 on that. The remaining $200,000 would actually just sit in the line of credit facility. But the benefit here is you're not paying any interest on those undrawn funds.
Heidi Armstrong: Why would somebody take out a line of credit? Well, they take out a line of credit if they want particular flexibility. It comes with a cheque book. But these days, what's a cheque book? The other thing is you can capitalise your repayments, which basically means that provided you have sufficient redraw, you don't actually need to make a repayment. Your repayments can actually just capitalise and effectively eat into your redraw.
Carla Baldock: The downside of a line of credit is that it normally attracts a higher interest rate.
Heidi Armstrong: At the end of the day, if you want to pay your loan off, you have to realise that a line of credit loan, particularly if it's an evergreen line of credit so there's actually no end due date at the end, you're going to find that at the end of your life if you haven't been diligent and you've just kept eating into your redraw and your equity, you're going to find that you're basically no further advanced as when you took the loan out to start with.
Line of credit equity loans gained plenty of popularity in the 90s for providing homeowners a new way to quickly reduce their mortgage balances. For those customers who understood how to use them well, a line of credit really did allow them plenty of flexibility and freedom to pay down a home loan very fast.
Unfortunately, for those customers without the necessary self-discipline and budgeting skills, lines of credit can be quite dangerous financially.
Of course, many homeowners learned that a line of credit allowed them to access the available equity in their homes. This is ideal for those wishing to complete renovations and have easy access to their funds as they needed them. Other homeowners learned they could use that unlocked equity to increase their investment portfolios. This enabled them access to funds to cover deposits on investment properties or to purchase shares and other investments.
As a line of credit can also be used as a regular transactional account, it offers the flexibility of streamlined banking for some people. This means they can deposit their entire salary into their home loan, effectively reducing the interest charges. They can then withdraw funds as they're required in much the same way as a regular bank account.
Table of Contents
- What is Home Equity?
- What is a Home Equity Loan?
- What is a Line of Credit?
- What are the Features of the Line of Credit Loans?
- What are the Disadvantages of Line of Credit Loans?
- How to use a Line of Credit or Home Equity Loan to Invest
- How to Access Your Equity
- How to Apply for a Line of Credit
- Who offers a Line of Credit Loan
- How to Keep Your Home Safe
- How Does A Line of Credit Equity Loan Work?
- How to Use Line of Credit Home Loans Wisely
- Line of Credit Home Loans Tips
- What do I need to apply?
- Pros and Cons
- Practical Example of a Line of Credit
The equity in your home is the amount you actually owe that isn't encumbered by a mortgage.
For example: if your home value is $400,000 and you owe $200,000 on your mortgage, the amount of available equity in your home is $200,000. For many people, this represents wealth accumulation. Unfortunately, equity can't be spent while it's sitting in brick and mortar form. This is where line of credit equity loans can be so helpful in unlocking those dormant funds so homeowners can put them to better use elsewhere.
What is a Home Equity Loan?
A home equity loan is a loan in which the equity of a home used as collateral instead of the value of the home itself, like in the case of a mortgage. Equity is defined as the difference between the mortgage amount and the value of the home. The interest rate for a home equity loan is based on the prime rate plus a margin. This type of loan is typically used to finance things like home improvement projects, expensive repairs, medical bills, vehicles, holidays, and college education.
In most cases, a homeowner will have both a mortgage and a home equity loan. In some instances, a home equity loan can be used as the primary mortgage type, but this does require plenty of self-discipline and strong budgeting skills. Some investors may use the proceeds of a home equity loan to finance the down payment on an investment property.
Some home equity lines of credit are available for up to 80% of the value of the home, and can be available for up to 30 years. The minimum monthly payment can go as low as only the interest due, though this prolongs the payback period and increases the total amount of money that must be repaid.
While the interest on a home equity loan can be deducted from the borrower's personal income taxes for people living in the United States, Australian citizens can only deduct the interest from their income taxes if the loan amounts will be used for investment purposes.
In order to be approved for a home equity loan the borrower must have excellent credit history, a good loan-to-value ratio and a decent combined loan-to-value ratio. In most instances, a borrower can only request a home equity loan that is equal to or lesser than the amount of equity in the house. And just like most other types of loans, there are fees associated with it. But every loan is different, so be sure to read the fine print.
What is a Line of Credit?
A line of credit, also called LOC or home equity line of credit, is a revolving line of credit with a variable rate that offers a lot of flexibility for the borrower. This type of loan allows the borrower to choose how often and how much to borrow against the equity in the house. The lender sets the initial limit to the credit line using criteria that is similar to closed-end loans. While a line of credit usually carries a shorter term than a mortgage, some are available for up to 30 years.
Unlike a regular loan that provides the borrower with one lump sum payment that must be repaid over a specific timeframe with monthly payments of equal amounts, a line of credit allows the borrower to access the funds as needed. And the money doesn't have to be used all at once. The repayment amount is dependent upon the amount of money that the borrower withdrew from the available credit balance.
Most lenders offer a line of credit to people that can manage their finances well. This can be shown by having good credit history and a stable income. Since the borrower can access the money whenever they want, it is tempting to take it out all at once, which is not the best option. The ideal recipient of a line of credit loan is someone that can resist the temptation to use up the loan money on frivolous things.
What are the Features of the Line of Credit Loans
There are many features of a line of credit loan that make this type of loan stand apart from all others. The most obvious feature of a line of credit loan is its structure. This loan allows people to use money from a credit limit, as needed. It works similar to a credit card. A borrower could be approved for a $100,000 credit limit, but only use $75,000 of it. The repayment amount is based on the $75,000 that was borrowed, which needs to be repaid over the term of the loan. At any time, the borrower can access additional money from the line of credit loan, as long as the total amount withdrawn does not go over the $100,000 credit limit at any given time. As money is borrowed and paid back, the monthly payment will change.
Another unique feature of line of credit loans is that borrowers only have to pay interest on the amount of money that was used, not on the total amount of the available credit. This means that borrowers are not charged interest on any unused money. It is a good incentive for people to only use as much money as they need to and not withdraw extra money simply because it is there and available. There are some line of credit loans that will allow the borrower to only pay the interest portion of the loan back in order to keep it under the credit limit.
The credit limit of a line of credit loan is dependent upon the property value. This is different than with other loans, which are usually dependent upon the equity of a house, the borrower's credit history, and their income. The more a person's property is worth, the higher their credit limit will be.
The final feature of a line of credit loan that makes it very attractive is that the money can be used for just about anything. The funds can be used for home renovations, house repairs, the down payment on an investment property, to purchase or refinance a vehicle, to go on holiday, or to pay for a college education. This feature makes a line of credit loan particularly suited to investors.
What are the Disadvantages of Line of Credit Loans
There are many ad vantages to a line of credit loan, but there are also some disadvantages that borrowers should be aware of. The first important piece of information is that a line of credit loan generally has slightly higher interest rates than the majority of other loans. The higher rates come into play because a line of credit loan has a higher risk of borrowers defaulting on their payments due to the flexible payment structure and the high credit limits.
The other disadvantage is for people that do not budget their money well. The flexibility of a line of credit loan and the non-traditional payment structure makes it hard for people who are not financially organized to pay back the loan as stated in the terms agreement. This is especially so because the monthly payment is not always the same from month to month.
Your monthly minimum repayment is shown on your statement as being only the amount of interest charged on the amount you owe. This makes it far too easy for many people to pay only the amount required without making additional payments to reduce the overall balance.
Add to this the ease of accessing funds whenever you want them, and it's easy to see why so many people end up owing exactly the same amount of money they originally borrowed. If you know you're not good with your money and you struggle with the self-discipline needed to keep making voluntary repayments into your line of credit mortgage, perhaps another loan type will be more suited to you.
How to use a Line of Credit or Home Equity Loan to Invest
The first thing an investor learns is that it takes money to make money, but what many people don't know is that they can tap into money they didn't even know they had: the equity in their house. Take, for instance, a home that is worth $400,000 with a mortgage of $250,000. There is $150,000 worth of equity in that home. This is a great sum of money to use for investing in such things as property investments. A successful property investor will get into the market and continuously grow their investments while using very little out of pocket money.
When a person invests in property, most find it very motivating to watch their capital grow, as well as the value of their entire investment portfolio, as property prices inevitably increase over time. This provides an almost completely passive way to earn a profit and is one of the main reasons why people that decide to pursue property investing end up sticking with it.
How to Access Your Equity
Every lender has their own eligibility requirements and approval process to decide who can receive an equity home loan or a line of credit loan. Each lender also has its own minimum and maximum loan amounts. For example, some banks may restrict equity home loans or lines of credit to a dollar amount between $20,000 and $100,000. Other lenders may limit borrowers to an amount that is no more than 60% to 80% of the value of their house.
To use a line of credit to access a home's equity, it is very similar to using a credit card. The homeowner can draw on the funds available in the line of credit facility as needed, and interest will only have to be paid on the amount that was used. There is a pre-approved limit for this type of loan, which is determined by how much equity is in the home. This figure is at the lender's discretion. Keep in mind that the line of credit is secured against the house. In other words, the house is the collateral and the lender can take it away if the borrower defaults on the loan.
There are several benefits to using a home equity loan to access the equity of a property. It is easier to be approved for a home equity loan than it is to get a line of credit because the funds are received in a lump sum and the lender immediately starts receiving a set amount of monthly interest payments. On a line of credit loan, the lender does not receive any interest payments until the borrower starts to use the funds, and even then, it's not uncommon to find that all the funds are not used at once. In this situation, it's a good idea to open an offset account attached to the mortgage to save the interest and make it easier to organise and budget the funds wisely.
When borrowers put the lump sum amount into an offsetting account, they are avoiding having to pay interest and the lenders are not making money. Since this isn't in the best interest of the lenders, many restrict the amount of equity that can be borrowed to 20% of the available amount. Some lenders will also ask for proof of how the money will be used, requesting copies of renovation or investment plans. To protect their own interests, lenders are changing their policies so that borrowers must use the money they are lent instead of having a lump sum of money sitting in an account for future use.
Another way to use a home equity loan to access equity is to use it to top up the mortgage. If a homeowner has a $300,000 mortgage and $250,000 worth of equity, the value of the loan can be increased by 80 of the equity value, or $200,000.
How to Apply for a Line of Credit
With all the requirements and restrictions lenders have regarding home equity loans and lines of credit, many are generous in allowing homeowners access to their equity because the house is used as collateral and the lender can ultimately take ownership of the home if the borrower is unable to pay. Lenders can also look at a borrower's history to see the types of loans they've had and if repayments were made on time. If you are considering a line of credit, there are some options to should be aware of.
Both lines of credit and home equity loans have fees associated with them. Before signing on the dotted line, speak with the current lender and try to negotiate the fees. Some lenders may be willing to offer homeowners a deal on a loan that fits their needs. Homeowners that change lenders could end up paying higher exit fees and break costs. But these costs are often waived if the homeowner stays with the same lender.
Always do the calculations and be aware of the interest rates. Line of credit and equity home loan interest rates are typically higher than the standard interest rate. Make sure your budget has room to account for the possibility of rising interest rates. A homeowner should be able to tell by looking at the budget and interest rate calculations to see if the loan is affordable for them, without stretching the financials too thin.
Finally, review the features of the loans. Upgrading a current loan could mean a borrower gains some great features, or important features could be lost. Ask about cheque book facilities, linked credit cards, and other similar types of features that may be missing from the current loan.
How to Keep Your Home Safe
From the lender's point of view, they have the security of the borrower's home in the chance that the loan is not paid. But it is important for the borrower to keep the home safe so that the loan can be paid off and the lender doesn't take possession of it. This is why it is important to do ample research and choose the best loan for the situation.
The prices of property fluctuate so do not borrow against equity that has been calculated on an inflated price of a home's value. When house values drop, the borrower will find out that they now owe more on the loan than what the home is actually worth. This is also why it's a good idea not to borrow or use the full amount of equity that is offered. Always leave a buffer.
How Does A Line Of Credit Equity Loan Work?
When purchasing a home, most people put a down payment on the price and then take out a loan or a mortgage for the rest of the cost. This means that most people start out with at least a small amount of equity in their home. In an ideal situation, the property's value will increase over time, and with regular mortgage payments the equity in the house will also increase.
A line of credit equity loan allows a homeowner to receive a line of credit up to the currently equity in the house. The lender defines the value of the equity, which may cost the homeowner a fee. Or the fee may be charged to activate the line of credit loan. In most situations, the credit limit is set at 80% of the value of the property.
The borrower can access the money at any time, without having to apply for it. Most line of credit accounts allow borrowers to access the money by using a special cheque or card. Other lenders have special internet banking accounts where the borrower can access the funds of the line of credit. The borrower can take out as much or as little money as they choose, as long as it doesn't go over the limit.
Once money has been drawn down from the line of credit equity loan, it may not have to be repaid right away. Repayments are only required when the loan limit has been reached. If a borrower decides to make repayments, it can be added to the line of credit. For example, if a borrower takes $10,000 from their line of credit and they pay back $100 a month, the repayment can be drawn from the line of credit so that the amount drawn down is now $10,100.
Some lenders charge monthly or annual fees on a line of credit equity loan. The average fee for a line of credit is several hundred dollars a year. This fee can be charged monthly, in six-month increments, or on an annual basis.
There is a way to save money on the interest paid during the life of the line of credit equity loan. A borrower can use their income to offset the loan amount. This is done by depositing all income into the loan account and then withdrawing money needed to satisfy living expenses from the line of credit as needed. With this method, the interest on the loan is only calculated on the remaining balance of the account, saving the borrower interest charges.
While a line of credit equity loan has fees and the borrower must be disciplined with the spending and repayment of the loaned funds, there are many benefits to having the ability to utilize the equity in a home when the need arises. One of the most attractive benefits of a line of credit loan is that it is the cheapest form of credit due to the low interest rates. Line of credit loans have significantly lower interest rates than personal loans, credit cards, and even some margin loans.
Unlike a standard loan that allows the borrower to deposit more money into the loan and then take it out as needed and charging a fee each time to do so, a line of credit equity loan allows the borrower to access the funds with only one set annual fee. This saves the borrower a lot of money because the money can be accessed as many times as the borrower would like, without having to pay a fee each time.
A homeowner can use the money in a line of credit equity loan for anything. The funds can be accessed to go on holiday, to renovate or make repairs on the property, to pay bills or to buy a new car. There is no need to submit an application to the lender to notify them what the money will be used for. Simply withdraw the money from the account.
People that are using a home equity line of credit for investments can increase their net worth. When making an investment on something that offers a strong growth rate and provides a good return, when the investor uses the money wisely to accumulate additional appreciating assets, their net worth will go up.
Homeowners that have the discipline and organisational skills to budget their finances wisely will find that they can leverage the equity in their home to strengthen their financial position and secure a comfortable financial future.
In most cases you will be borrowing less than the value of the property purchase your home. Therefore from the beginning you alone is worth less than the value of your property so as you continue to make a regular repayments and additional repayments where you can you are increasing the equity of your home, at the same time as property values increase. A line of credit equity loan includes features which:
- Allows you a line of credit up to the value of the equity in your home. Your lender will define the value of the equity in your home and this may cost you a valuation fee to activate your line of credit home loan. Your credit limit will be set at around 80% of the value of your property.
- Access to funds at any time without making an application to your lender. A line of credit allows you to access the funds with your links transaction accounts or using Internet banking at any time for any amount you choose.
- No regular repayments are required until you reach your limit. Your repayments can be added to your line of credit so for example if you have drawn down $10,000 and your repayment is $100 a month your repayment can be drawn from your line of credit so the amount drawn down becomes $10,100.
- Monthly or annual fees. There can be fees associated with a line of credit home loan which may be charged monthly, six monthly or as an annual fee. On average a fee for a line of credit will be several hundred dollars a year.
- You can save on interest using your income to offset the loan amount. You can have all of your income deposited into your loan account and then draw your living expenses from your line of credit as you require them. Your interest on your loan is then only calculated on the remaining balance of your account saving you interest charges.
While there are fees associated with a line of credit equity loan and you will need to be very disciplined bigger spending and your repayment to make sure you don't draw down more than you can afford, there are a range of benefits to being able to draw on the equity in your loan when the need. With a line of credit equity loan you could benefit from:
- Cheap credit. A home loan is the cheapest form of credit you will have available to you because the interest rate is much lower than that on credit cards or personal loans and even on some margin loans.
- Avoid fees for additional repayments or redraws. While a standard loan may allow you to deposit more into your loan account and then redraw when you need it, there are often fees associated with additional repayments and redraw facilities however with a line of credit loan you can access your equity amount for a set annual fee.
- You can use the money for whatever you choose. This means you can withdraw money from your line of credit equity loan to pay your bills, renovate, go on holiday or buy a new car and you don't need to make an application to the bank to show them what you are using the money for all you do is withdraw the money.
- Increase your net worth by using a line of credit for investments. If you use the equity in your home to make investments which offer a good return and strong growth rate, you can by increasing your net worth as you use your money wisely to accumulate more appreciating assets.
If you have the discipline and the financial wherewithal to manage your spending using a line of credit equity loan you can leverage the equity you have accumulated in your home to strengthen your financial position and secure your financial future.
How to Use Line of Credit Home Loans Wisely
Many people would agree that a line of credit home loan is easy to acquire and financial advisers swear that these loans are a powerful tool because of their flexibility. A line of credit home loan is a wonderful way to pay down a mortgage or finance sensible investments, when the borrower is disciplined and the loan is used wisely.
A disciplined person can use the proceeds obtained from a line of credit home loan without overspending and jeopardizing the repayment of the loan. This person understands that they will have access to a large sum of money, as much as 80% of the value of their home, but it will have to be paid back. The ideal person for this loan will only withdraw the amount of money they need, not an excess amount of money to be frivolously spent. This person will also understand the fee and interest structure, which can be lowered if income is parked into the line of credit account, such as wages and dividends, which will help to quickly pay off the mortgage.
It is also important to understand borrowers may be asked to pay a deposit of around 5% to get a line of credit loan. Wealthier customers may not be required to pay a deposit because they don't pose as much of a risk, meaning that there is higher chance they loan will be repaid without problems, unlike someone else with less income. Every lender has their own loan products, requirements, and fee structures, so know your lender's products or shop around for a loan that has terms that you can easily live with.
When a homeowner is in dire need of money and/or more time to pay off a mortgage, a line of credit loan can be helpful. Some lenders only require that the interest is repaid, which alleviates some of the worry of immediately losing the home. The disadvantage is that in the long run, the homeowner will end up paying more money into the cost of the home. Sometimes it is even possible to allow the interest to go unpaid and be capitalised into the loan. This is dependent on the terms of the loan and it will increase the debt, but many borrowers are comfortable with that and can then use the cash for other purposes, such as investments. The key to using a line of credit home loan wisely is to be financially responsible and organised, and knowing when not to get one. This type of loan is not suitable for everyone. It functions much like a credit card, so people not comfortable with carrying debt, having access to a large sum of money, or has trouble paying bills on time should not obtain a line of credit equity loan. If a borrower has trouble repaying the loan, he may try to switch to a different kind of loan, which is the same as refinancing. But people that do this often find that they don't have enough equity or a record of savings, which is a real issue in a time of declining property values. If you don't have a significant amount of cash reserves or equity, or you are buying property in a poor market, consider all the options and situations before getting into a line of credit equity loan.
Aussies can review a few key characteristics that will determine if they are a good fit for a line of credit equity loan. A good candidate for this type of loan has:
- Discipline to stick to a budget
- Consistently pays off credit cards every month
- Aren't bothered by slightly higher interest rates
A line of credit equity loan can be very helpful for a variety of situations, for the right people, but banks are seeing an influx of customers that are paying them down quicker. After all, it is a debt.
Line of Credit Home Loans Top TipsThere is a lot to think about when considering a home loan, no matter what kind of loan you'd like to get and what you intend to use the funds for. Here are some tips to keep in mind:
- Interest rates are typically lower on a home loan than commercial credit card interest rates, but lines of credit equity loans can have higher interest rates than other types of loans.
- The interest on a home loan can be minimized by placing all your income into the line of credit home loan account, and then withdrawing funds as needed to pay for living expenses.
- Credit limit amounts on home loans are normally higher than that of credit cards.
- Borrowers can easily access the equity funds in a line of credit home loan with cheque books, credit cards, or through internet and telephone banking.
- A welcomed benefit of home equity lines of credit is having the ability to keep withdrawing funds, up to the credit limit, without having to obtain approval.
- A home equity loan is a great resource for consolidating debt. It provides a means for borrowers to pay off all existing debts, including car loans and personal loans, while avoiding high interest. The homeowner can then pay the amount off with the lower home loan rates.
What do I need to apply?
Every lender has its own loan programs and application requirements, though there are some things that are required by law and are common practice for all lenders. Here are the most common requirements for applying for a home equity loan:
- Applicants must be at least 18 years old
- Name and address for each borrower
- Purchase date and price of the home
- Employment income
- Income from any other sources
- Outstanding balance on the current mortgage(s)
- The monthly payment on the current mortgage(s)
- Estimated market value of the home
- Requested loan amount
- Photo ID for all borrowers
- Previous address, if at current address less than two years
- Previous employer, if with current employer less than two years
Pros and Cons
There are a wide variety of reasons why a person would be interesting in obtaining a home equity loan or line of credit, but as with most things in life, there are advantages and disadvantages that must be considered to determine if a home equity loan is right for you. Here is a look at the advantages and disadvantages of home equity loans:
- Equity loans are lines of credit that are easier to obtain than other types of loans and credit cards.
- The loan can be used for a wide variety of things, from investments to home renovations to purchasing a new car.
- The funds can be withdrawn easily via cheque or 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.
- The interest charge can be reduced by depositing your salary and savings into the loan.
- Extra repayments can be made at any time.
- A mortgage reduction programme is a helpful way to manage an equity loan. Speak with the lender to see if this is an option for you.
- The interest rate is usually higher for an equity loan than it is for a traditional variable rate loan.
- Since it is very easy to access the money, and most equity loans and lines of credit are for a significant amount of money, it takes a disciplined and financially organised person to be able to handle this type of loan. It is important to make sure the money isn't used frivolously and that repayments are made according to the terms of the loan.
- If the loan isn't repaid according to the terms of the contract, the lender can take the property as payment.
Practical Example of a Line of Credit
The closest similarity to a line of credit loan is a credit card with a high limit. Let's take a look at some figures to put it into perspective:
If a property is worth $300,000 and the homeowner borrowed 80% of its value, the loan would be for $240,000. As the homeowner repays the loan, he can access any equity that is available.
This means that if the loan balance was reduced to $180,000, the homeowner could immediately access as much as $60,000 without having to apply to the lender.
A home equity loan or line of credit equity loan is viewed as an effective way to pay off a mortgage quickly or to make a sound property investment, but this is only beneficial if the borrower is very disciplined in his spending habits. An equity loan is not the ideal choice for many people because the temptation to keep the loan up to its limit is too great and the easy access to the large sum of money is irresistible.
With that said, equity loans work very well for disciplined borrowers and investors who have the need to be able to quickly access money in order to take advantage of any bargains or investments that come across their way. These loans also work well for financially organised homeowners that would like to renovate or repair their homes, or would like to purchase a new vehicle and not have to pay a high interest rate.
There are many great benefits to having a home equity loan or line of credit, and with the right discipline and knowledge about this type of financial products, a person can have a secure financial future with everything that they need in life.