- Line of credit loans are a revolving credit facilitiy attached to a home loan
- They essentially allow borrowers to access funds secured by the equity built up in their homes
- Lenders will set an upper credit limit with interest charged only on the amount accessed, not the whole amount
Line of credit home loans are not as common as they once were, largely usurped by home loan products with redraw facilities and offset accounts.
But it's worth understanding how they work.
What is a line of credit loan?
A line of credit loan acts as a sort of a giant credit card attached to your house, allowing you to access some of the existing equity you've built up in your property. Under a line of credit arrangement, you can withdraw funds up to a certain amount (the credit limit) as determined by your lender.
Line of credit loans are a form of revolving credit that can typically be accessed at any time, depending on the terms of the loan. And like a credit card, line of credit loans only charge interest on the amount accessed, not on the entire credit limit.
Example
If you'd been approved for a line of credit up to $100,000 and withdraw $40,000, interest is charged on the $40,000, not the entire $100,000.
Who offers line of credit home loans?
Line of credit loans are still offered by some select larger and smaller lenders. Many will lend up to 80% of a property's value with a line of credit loan, while some will lend up to 95% (although these may require borrowers to take out Lender's Mortgage Insurance).
Line of credit home loans: interest rates
As a general rule, lenders will charge higher interest rates for line of credit loans compared to standard variable-rate home loans. In some cases, they can be considerably higher – up to 100 basis points and beyond.
Line of credit loans generally require interest-only repayments to begin with before turning into an amortising principal and interest loan after a set period of time.
How do you calculate interest on a line of credit?
While line of credit interest rates may be higher, you only pay interest on what credit you use and, in some cases, you don't have to make regular or monthly repayments.
For some line of credit loans, you may not have to make repayments until you hit the credit limit. Bear in mind, this can cost you a considerable amount in interest over a long period of time.
Interest on a line of credit is calculated on the remaining balance in the account (similar to a credit card which accrues interest on any amount you haven't fully paid off). If you have a $200,000 line of credit loan and withdraw $50,000 to spend on a home renovation project, then it's the $50,000 that attracts interest charges, not the remaining $150,000.
What can you use line of credit loans for?
Line of credit loans can be used to fund a wide range of expenses, with some of the more commonly cited uses being:
- Home renovations and repairs
- Buying a second home
- Buying a car
- Paying for a holiday
- Paying for a wedding
- Investing in shares
So, if you were considering doing some major renovations to your home and have equity built up in your home loan, line of credit loans allow access to that equity.
They can also provide flexibility when you're not sure of the exact amount of funds needed. The ability to set a higher credit limit and withdraw more equity if you need it is one of the key advantages of a line of credit loan (although this can be a disadvantage too).
When you may need a construction loan
While a line of credit can be used for smaller cosmetic renovations, larger structural changes may require your home loan be refinanced to a construction loan.
Be sure to check with your lender if you are considering major renovations.
How do line of credit loans differ from personal loans?
While personal loans can be used to fund much the same things as a line of credit loan, they are quite different. Here are a few main variations:
| Personal loan | Line of credit loan | |
| Loan amount | Need to borrow a set amount upfront | Can access funds as needed up to a set amount |
| Terms | One- to seven-year loan terms | No set loan term; can be repaid within home loan term up to 30 years |
| Repayments | Must make regular repayments of principal and interest | Minimum monthly interest-only repayments can fluctuate depending on funds accessed |
| Interest rates | Often come with fixed interest rates | Generally have variable interest rates which may be lower (although this depends on the lender and individual credit rating) |
| Best use | Can be used for purchasing goods or services with a defined cost | Can be useful for ongoing costs or emergency use |
Line of credit loans: Pros and cons
It seems line of credit loans have distinct benefits: the main one being you can withdraw large sums of money with ease and flexibility.
But there are also a few catches. Let's consider some pros and cons:
Pros
- Lower interest rates: Can have lower interest rates than other options such as personal loans or credit cards
- Flexibility: Can be drawn on as needed for a wide range of purposes
- Higher credit limit: Can be used for bigger purchases
- Less rigid repayment structure: Require interest-only repayments on the amount of the loan you have accessed with some lenders only requiring repayment when credit limit has been reached
- Opportunity to increase home value: This can happen if line of credit funds are used for renovations or value-adding works
Cons
- Higher interest rates: Line of credit interest rates are generally higher than for a standard home loan
- Risk of high interest costs: Because borrowing and repayments are flexible, they can be costly if not used judiciously
- Can see equity eroded: Drawing against equity without adequate and timely repayment can see home equity plunge
- Not offered by many lenders: Less common in the current home loan market
What sort of borrower are you?
The key disadvantage of a line of credit loan, apart from having higher interest rates than a regular home loan, is the risk it carries.
Drawing too much on a line of credit and not making regular payments to reduce the principal can lead to heftier interest charges. It can also extend the term of your home loan while any built-up equity can be eaten away.
If you lack financial discipline, consider other options for accessing funds such as an offset account or redraw facility. This effectively sees you drawing on your own funds rather than your equity.
Alternatively, you could consider a personal loan since it has more structured repayments and sets a hard limit as to what you can borrow and a regular schedule for paying it back.
How to apply for a line of credit
First up, you'll need to have a fair amount of equity built up in an existing property to take out a line of credit loan.
Just to be clear, equity is the value of the property minus how much you owe on the mortgage tied to it. So, if you have a $500,000 loan and your home value has climbed to $800,000, you have $300,000 in equity.
Many lenders will cap what you can borrow at 80% of the property's value (sometimes higher if you pay Lenders Mortgage Insurance). So, on a $800,000 home, 80% is $640,000. You may also need to have paid off at least 20% of your loan amount prior to taking out a line of credit loan.
Once you've worked out how much you need, what you need it for, and how much you can actually borrow, you can seek a line of credit loan. To do this, you may need to prepare some of the following documents:
- A copy of the contract of sale for the property, as well as a letter from a conveyancer
- A document outlining your financial plan if you're buying shares or investing
- A building contract or quotes from a builder for renovations
- Quotes and information on anything else the loan is being used for, like a wedding or holiday
- The usual home loan documentation, such as your name and address, employment income, photo ID, the market value of your home, etc.
While fewer lenders are offering line of credit loans, they are still available on the market. Applying for one can be done in much the same way as a regular home loan, and if this is too much trouble, a qualified mortgage broker can help you with the process.
Savings.com.au's two cents
Line of credit loans can be a flexible option for people who want to access the equity built up in their homes, as they can provide relatively large sums of cash that can be drawn upon when needed.
But they aren't without their flaws and can by risky for people who lack discipline over their spending. If you view your equity as something to be spent and don't make regular payments to bring down the principal of the loan, you could find yourself in financial strife.
In worst-case scenarios, people have lost considerable equity in their homes or even had their properties repossessed when they've accessed more funds than they've been able to repay. Make sure you're clear on what you need a line of credit loan for, and stay committed to making regular repayments that reduce the loan amount.
In the current market, many borrowers are opting for redraw facilities or offset accounts to access built-up funds in their home loans. These options present considerably less risk as borrowers are essentially accessing their own funds or extra payments rather than drawing directly against the equity in their home.
As with any credit product, lines of credit loans shouldn't be taken out without careful research. The key is to shop around and compare products from a range of institutions to give yourself the best chance of finding a suitable product.