Note: This post pertains to retail “residentially secured” “home loan type” lines of credit only – those that are supplied by a lenders “retail” arm. Commercial property secured and business lines of credit (including where secured against a residential property may well have many differences.
A typical (residential property secured) line of credit (or “equity” loan) is a very flexible financial product, as it allows you to draw funds to a pre-determined limit, and allows normal transactional banking. A catch for some people is that these loans are usually interest only, and so without discipline, such a loan may never be paid off, if the limit is evergreen.
So why might I choose to get a line of credit?
Some reasons for getting a line of credit may include the following: Share trading, property investing, normal borrowing if you have a “lumpy” and irregular (but hopefully still sufficient) income, where you need to live out of the line of credit for months at a time, between income payments.
When might I choose another product?
100% offset loans, and all in one loans can be nearly as flexible as lines of credit, but often cheaper. Basic variable and fixed loans can cheaper and less flexible than the line of credit and other offerings. Some basic variable loans do not require repayments until you hit your limit, which may be your reason for looking at lines of credit in the first place. 100% offset loans can allow you to keep a lump sum in your savings account without any extra interest cost, and these savings can meet your repayments for a protracted period. If you want a fixed line of credit, you may need to do some research or contract a broker to find this product, as there are very few providers in the loan market in Australia.
So what are the different types of lines of credit?
The main differences between different lenders relates to what amount of repayments are required. Some require the interest to be paid every month in full, whereas others don’t care as long as you stay within your limit (called interest capitalisation).
What is an evergreen limit?
In theory an evergreen limit goes on until the lender tells you that you cannot have it any more. There is no predetermined date that the lender will cancel your credit limit. Some lenders state that the limit expires in (say) thirty years. Thirty years is a long time, so try not to get too concerned to start with!
What is a balloon payment?
Warning warning warning – if your line of credit documents mention there being a balloon payment required, this means that you may need to pay out the line of credit in part or in full at a certain time. Often there is a penalty interest rate 2% higher or so than the typical interest rate if you cannot comply. This is quite rare in standard retail lending.
Amortising line of credit:
This is where your limit reduces over time, maybe to a zero limit on a 25 year or 30 year term. Just be aware that you need to watch your limit carefully to avoid those $50 overlimit fees.
Review period:
In rare cases there may be a two yearly or five yearly review of your line of credit. This can be quite dangerous as you are re-assessed to ensure you still qualify for the finance, and can get bumped up to a higher “default” rate, or forced to refinance at this review stage. In my opinion you should avoid such finance if you can, for residential and business / commercial purposes. You never know what your circumstances will be on the review date. You may be between jobs etc etc. If you have a review coming up, try to ensure you have the review done when you are in a strong position. Make up an excuse that you need to make some long term plans etc if necessary (especially if you are about to go on maternity leave, or swap jobs, or start a business or go on an extended trip to Europe. Get something in writing as to when your next review will be if your review is successful. Always assume the worst case scenario. If the review solely consists of a check to see that your repayments have been consistently on time and you have stayed within your limit, try to get something in writing to confirm this, as this is not as bad as a full credit assessment. BTW – there are competitive commercially secured products out there with no review periods, but you need to track them down.
What are the pricing issues?
A line of credit can be at a significantly higher rate if it is not part of a professional package, and or a limit below $250,000 or so. If you are borrowing at less than (say) $250,000, consider an interest only all in one loan, or interest only basic variable. If you don’t plan to have lots of transactions out of the account, then the line of credit features may be wasted. The workaround might be that you can redraw from your loan account to a savings account and then credit the funds from there to where-ever it needs to go (if an investor, just make sure it is easy to see exactly what the purpose of the transaction is – speak to your accountant about this – if the money is not clearly used for an investment purpose, you may not get a tax deduction for all of the interest on the line of credit). If your loan has a bsb and account number, it will be easy to transfer money into the loan.
When can the lender cancel or reduce my limit?
There will be a condition in your letter of offer that the lender may reduce or cancel your limit at any time, or within a certain period of notice. In my mortgage broking days, I never had any of my clients have their limit reduced or foreclosed on (but know that lenders do do this). However if you make sure you make all of your repayments on time, and don’t bring attention to yourself for any reason, this issue hopefully will not arise. Where lenders find that there has been fraud in an application, or the double whammy of missing repayments and your security property being in an area that has lost considerable value – you will significantly raise your chances of problems. If you are going to demolish all of part of your security property (and rebuild?) – go to the lender before you start and arrange things properly, or you may face some significant risks. This is the same with all loans – however if they are owner occupied purpose and regulated by the UCCC, there is some extra protection.
See . . . what rates might be worth fixing at?
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From . . . www.fixedversusvariable.com.au
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