Many homeowners can apply for a line of credit loan, but some may not know the best way to use it. If done correctly, a line of credit can give you financial returns time after time.
Using a line of credit can be not so smart in some circumstances, but could be smart in others. It is also human nature to pay into commitments and to spend what’s left over.
The equity in your home is the difference between the value of your property and your mortgage balance. With a line of credit, you can use this equity as security in order to get another loan, which could essentially be, a second mortgage. But there are some dangers to doing this - like any loan you will need to pay fees and interest, reduce the equity in your home and risk the chance of losing your home.
So what are some of the best ways to use your line of credit? Traditionally finance experts have advised homeowners to use their line of credit in emergencies, such as the possibility of losing your job. Some finance experts even suggest to not touch your equity at all.
‘Whenever I am discussing line of credit with clients I stress that they are not for everyone’ says Kim Wight, Mortgage Broker, Sydney. ‘As a line of credit does not require regular repayments to be made to reduce the debt. Unless clients are controlled and have good financial skills they run the risks of having a debt they will never pay off and will pay a large amount of unnecessary interest on.’
If you’ve got equity to use and don’t need it for emergencies, it may a good way to use it as a capital investment. But according to Ms Wight, for the older generation, keeping money on the side may be helpful. ‘As clients get closer to retirement they often have paid off their home and are asset rich and cash poor. They worry how they will be able to raise money for any future emergencies. By setting up a LOC they have funds available as a” just in case’’. The interest on a line of credit is cheaper than a reverse mortgage.
Some examples of capital investment include;
- home improvements that could increase the value of your property
- university funds for the kids
- other financial moves that have a good chance of providing an equal or better return on your money
Real estate investment
Today, a competitive property market can make a real estate investment property a potentially good investment, but only over a long period of time.‘Many investors use the equity in their current property to buy their investment property but when they need to pay the 10% to exchange the contract they do not have the funds’ says Ms Wight. ‘By setting up a LOC they can have the money to pay the deposit and they simply pay it back to the LOC at settlement of the new investment property from the investment loan funds. The LOC gives them the deposit money time and time again for each new purchase.’
If you do consider a line of credit loan to buy real estate, be sure that the rental income will compensate for most of your carrying costs or that you have enough financial security until the investment pays off.
‘If the property is purchased as an investment as an investor you need to be able to account for the interest paid on your investment loan in order to be able to claim a tax deduction’ explains Ms Wight. ‘If you are drawing and redrawing on the LOC the exact amount of interest you can claim can be difficult to prove to the ATO and you could find yourself being audited by the tax department and having to explain your interest expense.’
What shouldn’t you use your line of credit for
Industry expert: Kim Wight’s tips for your future financial health
To consolidate debt homeowners may have difficulties with budgeting and managing their money. Giving them access to a LOC where they can continue to draw and redraw they may not be able to control themselves and the purpose of reducing their debts with the consolidation may not be achievable.
A Line of Credit can give you access to money to achieve many of your financial goals but before you take this form of finance ask yourself what is your plan and time frame to pay the debt off. If you cannot commit to a payment strategy a LOC may not be right for you and a loan with set repayments and term might be your best options for your financial future health.
Although some finance experts agree that you shouldn’t use a line of credit to buy luxury items like cars, boats and holidays, Ms Wight confirms that it is fine to reward yourself every now and again.
There comes a time in life when you have worked hard and paid off your home and provided for your children. Borrowing small amounts of money is not about the financial return but about a personal and lifestyle return you usually cannot afford to enjoy. It would be a sad and miserable place if money were only used to make more money. Life also needs to be lived and enjoyed.
‘Many clients as part of their salary have car allowances and change their vehicles every few years’ she says. By setting up a LOC they can pay the loan down over a period of time and then use it again to update their vehicle. Control has to be taken with this as you do not want the debt to still be there when you have disposed of the car.’
The same applies to holidays according to Ms Wight. If you’re about to access your superannuation, using your LOC may be suitable. ’Often clients have paid off their home but do not have savings as it may be tied up in superannuation. By setting up a LOC for travel they can have their holiday then pay the LOC down and reuse.’
Using your equity to make repayments on the line of credit loan itself or other debts like bills or credit statements, may be a sign of financial distress. If you feel as though you need your line of credit for everyday expenses, than you may want to consider financial counselling.
However, the most effective way to spend the equity is to make home improvements. If you can’t make the repayments, you risk foreclosure - but if you use the equity to improve your home, you could see an increase in its value.
It would seem to me that if they can’t make the repayments they can’t afford to get the LOC. Increase in value may help them if they have to sell am may help them clear the debt.
Projects that can have the most financial impact
- Kitchens. Real estate ads usually mention the updated kitchen features and people tend to favour kitchens with updated features.
- Bathrooms. The same applies for bathrooms, modernising older styles can result in good returns.
- Outdoor improvements. They say first impressions last, so your if your house makes a good impression quickly, modernising the outdoor appearance could be smart investment. Fibre cement and landscaping are both costly, but can also yield very good returns.
- Roofs and windows. These are quite expensive to replace and buyer expect these to be in good condition. While replacing these won’t increase the property value as much as kitchens and bathrooms, it could discourage buyers.
‘If you are doing renovations and have a construction loan the lender will dictate how much and at what stage of the build they will make payment to the builder’ confirms Ms. Wight. ‘Having a LOC allows you to take advantage of any discounts that might be available on personal choice items and also may allow you to negotiate a better deal with your suppliers. You control the funds not the lender which is always preferable.’
Projects that can potentially negatively affect resale value
There are a number of renovations that could potentially affect the resale value of your property. Generally, if your renovations are more personal, meaning they’re made to suit your lifestyle, then it may have a less positive effect on the resale value. This doesn’t mean that you shouldn’t do the renovations, but keep in mind that it may not add value to your home.
- Luxury upgrades. High quality upgrades may not have the return of mid-range ones unless the area or location is a high-end one. While marble floors may be enticing to you, it may not be for your buyers.
- Garage conversions. Garage conversions can give homeowners much needed space, but many buyers may want a garage, so converting this space usually won’t increase value.
- Swimming pool. Consider whether the pool will be usable for most of the year. Keep in mind that there are many regulations you will need to follow and could pose as a safety hazard by parents with small children.
Other things to consider when renovating your home
- Look at other properties in your neighbourhood. If you live in a neighbourhood where it’s normal to have two-bedroom, single story houses - then adding a second story to your house may not see a high return. However, if your neighbours are making similar improvements, then it may be a sign that you should too.
- Stay within the price range in your neighbourhood. Balance out the renovations according to the values in your neighbourhood. Spending $30,000 remodelling a kitchen for a property worth $150,000 don't nearly have the same result as it would in a $500,000 home.
- Your renovations should sync with the rest of property. Focusing narrowly on one room could be a mistake, if the rest of your house was updated a while ago, it could look out of place compared to the upgraded rooms.
Projects vs luxuries
For a property worth $500,000, projects can add beyond $35,375 to the property value and could potentially attract more buyers.
New KitchenCost: $25,000
Value added: $19,500
Value added: $9,875
Value added: $6,000
2013 Nissan Pulsar SSS Drive AwayCost: $19,990 drive away
Value added: Depreciating asset
Most expensive cocktail in the worldCost: $12,500
Value added: a good night out
Most expensive gaming chair in the worldCost: $6,000
Value added: a fun gaming experience