A line of credit is a form of lending that can be very useful or it can be grossly abused. Essentially, a line of credit is a loan facility which allows direct transactions into and out of your loan account up to a prescribed limit. While this sounds great in principle, it can be detrimental to your debt objectives.
These facilities are used to allow people to draw back into their loan account up to their credit limit for any worthwhile purpose. Such purposes are to do renovations to your home, or to pay out some debts, to furnish your home or buy another investment. Often however, they’re used to buy boats or something else which is more expensive than it is essential, but which can easily be done with the facility. There’s no applying to the bank for each purchase – normally it’s like a keycard arrangement. This makes it all too easy to spend unnecessarily, and, because a line of credit is interest only, and so you only need to make interest repayments, by overspending, you don’t pay down the principal of your mortgage.
The line of credit loan limit is normally up to 80% of the value of the property, but can go to 95%. This means that if you’re refinancing and you only owe 70% of the value you can actually get a line of credit up to 90%, so then you’ll have an extra 20% to use for your purposes. Lines of credit can form your loan in its entirety, ie the full 90% in this example, or it can be made to be a split part of your full home loan, so you could have say 80% as a traditional principal and interest loan, with only 10% as the line of credit. When used as a split like this, the usefulness is often maximised, but the potential downside is greatly reduced.
The other use of a line of credit is to pay down your mortgage quickly. You can divert all of your income into your facility and live on a credit card for the month. This way the interest calculated is based on a slightly smaller principal. This structure is exceptionally effective when combined with the traditional loan structure, but it normally needs to be put together by a professional broker to keep everything in line. This has a similar reduced interest goal as the offset accounts that are very popular.
As an alternative to a line of credit with a small limit, ‘cash out’ is often used. This is normally a very limited amount, and normally for specific purposes. So here a line of credit will be far easier to use and is more likely to be helpful over a longer period if discipline is maintained. And that’s the crux of a line of credit – discipline.