A line of credit loan might be a suitable choice for borrowers looking to access some of their built-up equity to meet short or long-term financial needs.
What is a line of credit loan?
A line of credit loan acts as a sort of 'credit card for your house' where you can access some of the existing equity you've built up in a property. You can withdraw money up to a certain amount (the credit limit) determined by your lender.
Line of credit loans are a form of revolving credit that can often be accessed at any time, depending on 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. If, for example, you'd been approved for a line of credit loan of $100,000, and only withdraw $40,000, then you'd be charged the loan's interest rate on that $40,000, not the entire $100,000.
Line of credit loans are becoming far less common with the rise in popularity of offset or redraw accounts that essentially offer similar features. However, some smaller lenders still offer line of credit facilities. Of these, some will lend up to 80% of your property's value with a line of credit loan, although there are some that lend as much as 95% (although these may require you to pay for 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 much higher – up to 100 basis points and beyond.
Line of credit loans are usually interest-only 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 considerable money 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 an overseas holiday, then it's the $50,000 that attracts interest charges and not the remaining $150,000.
What can you use line of credit loans for?
Line of credit loans can be used for a wide range of purposes, with some of the more commonly cited uses being:
- Home renovations and repairs
- Buying a second house
- Buying a car
- Taking a holiday
- Paying for a wedding
- Investing in shares
So, if you were considering doing some major renovations to your home and have a chunk of 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 (and can be a disadvantage too).
Larger renovations require a construction loan
While a line of credit can be used for some smaller cosmetic renovations, larger structural changes might require your entire home loan to be turned into a construction loan. In some cases, a lender may require your entire loan to be refinanced. It is always worth checking with your lender.
How are line of credit loans different from personal loans?
Personal loans are quite different from a line of credit loan. First of all, personal loans generally have a loan term between one and seven years, meaning the loan must be repaid in full by the end of the term. Lines of credit, on the other hand, have no set time the funds must be repaid. Instead, the lender accesses money up to a certain limit and makes repayments on an ongoing basis.
Secondly, line of credit loans have variable interest rates, while personal loans can have fixed or variable rates.
Also, their repayment structures are quite different. Most line of credit loans require interest-only repayments on the amount drawn, while some even allow interest costs to be added to the drawn balance up to your approved limit. Personal loans generally have much stricter terms, with minimum principal and interest repayment requirements and less flexibility.
Lines of credit can also have lower interest rates, although this can vary based on the lender and your credit rating.
Line of credit loans: pros and cons
It seems line of credit loans have distinct benefits: you can withdraw large sums of money with ease and flexibility. But there are a few catches.
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 exorbitant interest charges. They can also extend the length of your home loan and the loss of built-up equity.
If you lack discipline, consider other options for accessing your equity like an offset account or redraw facility. Alternatively, you could consider a personal loan since it has more structured repayments and sets a hard limit as to what you can spend.
Here is a general guide to the advantages and disadvantages of line of credit loans:
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Pros
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Cons
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How to apply for a line of credit
First things first, you need to have a fair amount of equity built up in an existing property to take out a line of credit loan. Equity is the value of the property minus how much you owe on the mortgage tied to it. A $500,000 home with $200,000 already paid off means you have $300,000 in equity.
Many lenders will cap what you can borrow at 80% of the property's value, as mentioned before, (sometimes higher if you pay Lenders Mortgage Insurance) but this is still a pretty sizeable amount. On a $500,000 home, 80% is $400,000, which is hardly pocket change. You may also need to have paid off at least 20% of your loan 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 do it for you.
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 large sums of cash that can be drawn upon when needed. But they aren't without their flaws and shouldn't be used by people who lack control over their spending. If you access your equity too recklessly and don't make regular payments to bring down your principal, 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 have accessed more funds than they have been able to make repayments on. So, make sure you really think about what you need a line of credit loan for, and stay committed to making regular repayments that reduce the loan amount.
As with any home loan product, lines of credit shouldn't be taken out without careful consideration. Research is key, so be sure to shop around and compare line of credit products from a range of institutions to give yourself a better chance of finding a suitable product.
This article was originally published by William Jolly in September 2019 and was updated by Denise Raward in February 2023.
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