A line of credit (LOC) loan, also known as a home equity loan, enables borrowers to draw funds out of the equity in their property as and when needed.
Borrowers can either take out an LOC as a new standalone home loan or choose to split their current home loan with an LOC facility.
Depending on your lender's policy, an LOC can be split with almost any other home loan product.
Property investors tend to use an LOC to draw on the equity in their existing properties to use as an instant deposit for another one or to complete renovations.
For business owners, an LOC is often a cheaper alternative to an overdraft, which can attract interest rates of around 15% per annum.
Business operators, too, often use theirs for multiple transactions or to place large orders of stock, and pay the money back into their account at a later date.
An LOC facility is similar to a credit card – although with a lower interest rate and a higher limit – and therefore it requires a great deal of financial control, says Robert Slocombe, head of strategy, product and marketing, AMP Banking.
"A line of credit is like having a large revolving overdraft against your home," Slocombe says.
"Used wisely, it can save you thousands in interest over the term of the mortgage by depositing your income and any additional funds into the account and drawing out only your minimum requirements," he explains.
"It does need a high level of discipline, though," he adds.
Line of credit products have become very popular in recent years, largely due to its great flexibility. However, you need to understand how to exploit its features to their full capacity to maximise its benefit – and failure to do so could be hazardous to your financial health.
"Given the accessibility of any additional funds paid into the loan and that you never have to pay the debt off, LOCs can be bad news for people with no self-discipline," says Margaret Lomas, founder of Destiny Financial Solutions.
"In addition, the ease with which many lenders provide an 'increase' to limits as your home value increases results in many people getting caught up in a loan that they simply keep extending – often past the level at which they can comfortably meet the commitments."
How it works
An LOC is an amount of credit secured against your property with a minimum-interest-only repayment schedule which may last the full term of the facility. In the mortgage industry, this sort of arrangement is termed 'evergreen'.
The limit for an LOC is determined by the equity available in your property and your ability to make the minimum-interest-only monthly repayments on the entire amount available – that is, if you were to withdraw up to your limit, including capitalisation of your interest if the product allows you to.
This limit is traditionally capped at around 80% LVR, depending on your lender. For example, if you have $200,000 left to pay off your mortgage and your home is worth $600,000, your credit limit is capped around $320,000.
While LOC borrowers are not required to make more than the minimum interest-only repayments each month, they also have the option of making monthly principal and interest repayments.
For further flexibility, LOC borrowers can also make large one-off principal repayments to reduce the credit used. However, as the facility has no loan term, there is no obligation to pay down any of the principal until the credit limit is reached, or you choose to pay off the facility and close it completely.
"A line of credit allows you to move around within your predetermined limit in any way you like, as long as you meet your commitments," says Lomas.
"This means that you must pay the interest bill when it falls due, and stay within the credit limit provided, but you are not required to reduce the balance," she explains.
Interest is usually charged at a premium of about 0.1% above variable rates, but may be slightly higher depending on your financial circumstances and features taken with the loan.
2. Lending criteria
An application for an LOC is assessed in a similar way as that of a regular home loan. You are considered on your individual financial position and the value of the property you are taking the LOC out against.
As with many banks and non-banks, due to the ongoing credit crisis, lending criteria may have tightened to factor in higher costs of lending. This is likely to be maintained throughout 2008/09 because of the global economic instability.
Benefits vs risks
The main benefit of having an LOC facility, however, is that you’ve got money at your fingertips if and when you need it. But, although this is handy for business owners, it can be the ultimate trap for owner-occupier borrowers.
Accessing the facility works like using a transaction account and a home loan account rolled into one.
This gives you access to your credit by such means as ATMs, credit cards, debit cards, internet and phone banking, and cheque book.
You can also withdraw all the finance you want from your LOC, up to the certified limit, without gaining pre-approval or having to top up your current home loan.
It's important to note, however, that there are real risks involved in taking this product. For example, many LOCs can be called in (ie, terminated early by the lender with full repayment required).
Also, because an LOC is akin to 'eat all you can' credit, this can result in massive interest bills and borrowers making
no progress in regaining the equity in their property.
This scenario, unfortunately, is remarkably common.
Why take a line of credit?
Lines of credit are taken out for a number of reasons – and each has its benefits and risks for different types of borrowers.
For very disciplined owner-occupier borrowers, an LOC can help pay off a home loan faster.
An LOC is both a transaction account and a loan in one facility, and it works similarly to an offset feature in a standard variable product.
You are able to deposit and withdraw funds as required through your transactional account and the money that is deposited in your LOC pays off the balance withdrawn previously – much as you would pay off your credit card. Once the balance is paid off, any additional repayments to the LOC’s principal 'offsets' the interest charged on the original home loan.
By depositing all your income in an LOC transactional account, you can use a credit card throughout the month for purchases. Then, when the time comes to pay off the credit card, the money is taken out of the LOC account.
In the meantime, the additional income left in it is offsetting the interest charged on the facility – or even your home loan if you have not made any withdrawals from it.
While this may work well for those borrowers who have high disposable incomes and sound financial strategies, it is advisable that this facility be restricted to long-term investment uses such as home improvements.
Lomas believes an LOC can be a useful tool for property investors as they can add to and withdraw from the account as they increase or reduce their property portfolio.
"At the beginning of your investing journey, you can get one loan which you add to as you acquire properties," Lomas explains.
"You can then pay it down as quickly as possible and use the equity to provide deposit funds for more properties, while you apply for an increase of the entire amount.
"As you always have the one loan – and the one loan account number – you can set up direct debits and other regular payments and not have to change them every time you get a new one."
The business person
John Mohnacheff, managing director at BEAT Home Loans, says that LOCs were first designed to provide funds on a 'needs basis' rather than just as a splash fund.
This makes an LOC perfect for a business owner with a mortgage against their home or against the property their business operates out of.
"If the line of credit is used for business purposes such as a commercial purchase or an investment property, that interest component is tax deductible, and this is an extremely cost-effective way of funding these types of transactions," Mohnacheff explains.
So, if you are thinking of using an LOC to help manage your business cash flow, you should restrict the usage to business-related costs and keep your personal expenses out of it. Then, when it comes to tax time, it makes it easier to assess your tax deductions.
Considering your alternatives
It's important that borrowers applying for an LOC facility for their mortgage or as a standalone home loan are aware of all the other options and alternatives.
If you're not using the funds for a deposit on an investment property or to run your business, you might consider opting for a regular standard variable rate product.
Kit Wong of Nationwide Mortgage says that, in most cases, you can find a good standard variable rate loan with a competitive rate – as well as competitive fees and charges – which is lower than that of an LOC, and which allows you to make additional repayments and redraw without penalty.
"You can use a standard variable home loan in the same way if you're a high transaction customer," she explains, "so you should look at whether the LOC is what you need, or whether you can find it in a variable interest rate home loan."
It's vital that you get professional financial advice before considering any move to using an LOC facility.
This is for two reasons. One is that refinancing costs thousands of dollars in exit fees. The other reason is that you may not be able to afford the increase in monthly repayments that an LOC attracts.
Putting a hold on your LOC
Although your bank cannot 'freeze' your LOC, it has the right to step in and suggest other alternatives if it feels you’re not coping with the added responsibility.
"Most lenders also have the right to review a LOC facility annually," says Mohnacheff. "I don't know of too many who’ve exercised that right, however, except when a loan goes into arrears – and then the proverbial has hit the fan, anyway."
It's important that you know the terms and conditions of your LOC before you sign the contract as, Wong says, you may be charged a penalty for not drawing down on the facility.
"Check out exactly what the facility involves and what it includes, as there could be penalties for not drawing down 50% or so of it," Wong advises.
"Also check the interest rate, as well as the terms and conditions of that part of the home loan before you sign the contract, because it could be set under different ones to the average standard variable home loan."
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