What is a line of credit home loan and how do they work?

A line of credit home loan can give you access to a pre-approved level of credit whenever you need it. This might be helpful if you are planning on renovating your home or looking to buy an investment property, although it’s also important to be aware of the risks and potential costs involved.

What is a line of credit home loan?

A line of credit home loan allows customers to borrow money using the equity in their home.

Similar to a credit card, you have a pre-approved limit on a line of credit loan, and you can flexibly use the loan up to that limit without having to apply each time you want to borrow money.

In other words, it is a revolving credit facility that you can use to invest, renovate, or use as a rainy-day buffer, for example.

Generally speaking, with a line of credit:

  • You can draw funds up to your approved limit whenever you need.
  • You only pay interest on what you’ve used of your available credit. For example, if you had a $100,000 line of credit and you drew down $50,000, you would only be charged interest on that $50,000. This interest would generally be added to the loan each month.
  • You can typically make interest-only repayments or let the interest be added to your home loan balance (capitalised) up to your approved line of credit limit. Capitalising interest does mean that you will reach your approved limit sooner, compared to making interest-only repayments. You’re also usually free to make as many repayments as you like.

If your lender allows it, you may want to set up the line of credit so that your salary is paid directly into the loan, and you pay your bills, make credit card repayments (if applicable) and withdraw money directly from the loan itself.

This way, a line of credit can work both as your bank account and your loan, with your savings going towards paying off the loan faster.

Line of credit
Source: Rawpixel.com (Shutterstock).

What are some of the possible pros and cons of a line of credit home loan?

Pros:

  • Flexibility when it comes to when you access funds as well as when and how you make repayments
  • Funds are available for a rainy day or investment opportunities
  • If it suits your circumstances, having your savings in the loan, may allow you to pay it off faster

Cons:

  • Can have a slightly higher interest rate than standard principal and interest home loans
  • If you make interest-only repayments or if interest capitalisation is applied, this may mean you end up paying more in the long term
  • Lenders are typically stricter when approving a line of credit loan

Interestingly, the same flexibility and easy access that can make a line of credit attractive is also one major reason people should exercise caution when considering one.

For example, since borrowers don’t necessarily have to pay the interest on a line of credit back straight away, there is the risk some may forget that the interest is still being charged and still being added to their loan balance. This can potentially lead to more debt. The loan must be paid off before the end of the loan term, which is typically 30 years. An evergreen line of credit does not have a loan term and so never needs to be repaid, however this type of loan is offered by few lenders and is rarely approved.

A line of credit home loan is not for everyone. Instead, you may want to consider whether other loan features are more suitable for you. For example, you may be able to get similar benefits through a 100% offset account.

Why might a line of credit home loan be suitable?

Because of some of the factors mentioned above, generally a line of credit may be more suitable for investment purposes and necessary expenses, rather than funding a lifestyle. This is because the full flexibility of a line of credit is only needed by some borrowers, while the potential risks that need to be managed may make this arrangement unsuitable for some people.

A line of credit could potentially be suitable for borrowers such as:

  • Investors who want to have funds on standby to invest when opportunities arise.
  • Business owners who have seasonal cashflow and need extra funds at certain times.
  • Home owners wanting to purchase a new car, pay for the kids’ education etc. up to their pre-approved limit without having to apply for a new loan each time they want to borrow money.
  • People looking to pay for renovations where there isn’t a fixed building cost and budget. For example, they may suit minor renovations, landscaping or cosmetic improvements.

On the other hand, if you simply need somewhere to park your money while keeping it relatively accessible, a savings or transaction account may be of more interest to you.

Line of credit home loan
Source: Rawpixel.com (Shutterstock).

Three things to consider before applying for a line of credit

First of all, lenders will usually ask why the flexibility of drawdown and repayments that a line of credit can offer is important to you. They do this to help determine if this type of product is suitable for you.

Secondly, it’s important to understand that higher interest rates generally apply to a line of credit when compared to a principal and interest home loan. Not paying off the principal amount will result in more interest being paid over the loan term. You will usually make interest-only repayments, or repayments may not be required if interest is capitalised, so financial discipline is needed to repay the loan. Additionally, in some line of credit contracts, the lender has the discretion to reduce or cancel the limit at any time. This means customers may be required to pay off the amount owing at short notice, and would need a plan for doing so.

Finally, lenders usually want to know how you’ll pay off the line of credit. Depending on your financial situation, an acceptable exit strategy could be repayment of the loan prior to the end of term, downsizing, sale of assets, savings or income from other investments. A typical term for a line of credit is 30 years however some lenders offer an evergreen line of credit which lasts forever in a similar way that a credit card does.

How do you apply for a line of credit home loan?

Not all home loan lenders offer a line of credit home loan. Speak to your current lender to see what options may be available to you. You might also want to speak with a mortgage broker or seek independent financial advice if needed.

In addition to the standard loan documents such as pay slips and statements for your current home loan, in some cases lenders may also ask people applying for a line of credit to provide evidence regarding their intended use of the funds.

Most lenders will also do a full assessment including credit checks and serviceability (borrowing power) assessments, primarily because they want to ensure that this loan product will meet or fulfil your requirements, objectives and needs.

What are some of the possible alternatives to a line of credit home loan?

A line of credit is one of many ways to access the equity in your property. Some of the other common options include a redraw facility, a 100% offset account and releasing equity from your property.

There is a minimum loan amount associated with most line of credit home loans, so for smaller loans (up to $20,000, for instance), you might want to instead consider a personal loan. Some personal loans also come as a line of credit.

For larger amounts, you may want to consider a more traditional home loan with a 100% offset account as these typically have lower rates and lenders may be more lenient when approving them.


Otto Dargan

About Otto Dargan

Otto Dargan is the Managing Director of Home Loan Experts, an online mortgage broking firm that specialises in helping people who fall outside of normal bank criteria get approved with a major lender.

This article was reviewed by our Sub-editor Tom Letts and Finance Editor Sean Callery before it was published, as part of our fact-checking process.

Main image source: Jirsak (Shutterstock). 

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