There are many types of loans specifically designed to suit the lifestyle and financial needs of different people at various stages in their lives.
And for those borrowers who have already built up some equity in their home but require a degree of financial flexibility, a line of credit (LOC) loan may be an effective solution to helping them meet their needs.
So how does a line of credit loan work?
Essentially, these loans function similarly to a credit card, where you are allowed to borrow up to a certain amount of money within a fixed period of time set by the lender, but there are significant points of differentiation from other loans, based on how borrowers can manage the process of their withdrawals and repayments.
The key features of the line of credit loan are:
- During the life of the loan you can withdraw money as you need it and you do not need to notify the lender what the funds are being used for each time you withdraw.
- As you pay back the principal amount, your creditamount continues to revolve and you can use those line of funds again as you need to withdraw money.
- You only make repayments based on how much you borrow, against your maximum, pre-approved amount. This is where the line of credit is similar to repaying debt on a credit card.
- You can pay back any amount as long as you make the minimum monthly payments set by the lender. Minimum payments may be a combination of interest and principal, or interest only.
- As the loan structure is not viewed as traditional in nature, the interest rate is usually set above the standard variable rate by banks and financial institutions.
How does a line of credit loan differ to a personal loan?
The line of credit loan is different to a personal loan, where you get a lump sum and you agree a fixed or variable interest rate and have a fixed term for repayment.
As a line of credit loan is secured against your home equity, unlike a personal loan which is often unsecured, the interest rate on a line of credit loan is usually lower than on a personal loan.
How does a line of credit loan differ from a credit card?
As with a personal loan, the interest rate on the line of credit loan is also generally lower than that on a credit card, which is why some borrowers choose to opt for this loan, rather than simply increasing their existing credit card limit or taking on a credit card.
What would you use line of credit loan for?
In many cases, line of credit loans are used by people whose borrowing needs vary and who therefore want some flexibility around withdrawals and repayments.
These types of loans are often used for:
- Home renovations and repairs
- Buying another property
- Taking a holiday
- Buying a car
For example, you may have equity in your home and are considering whether you do a major renovation or make a series of repairs and minor alterations.
You don't necessarily know how much money you will need, so opening a line of credit can give you the flexibility to pursue your project knowing you can draw down sufficient money to complete it.
Being smart about your line of credit loan
Financial discipline and organisation will help you manage your debt on a line of credit loan. There are several simple ways you can utilise its features to your full advantage:
- One common way of reducing the cost of the loan is to have your income deposited into your line of credit loan account to offset the overall loan amount. That way the interest on the loan is only calculated on the remaining balance of the account, which will lower your overall interest charges.
- Likewise, any planned or unexpected income that you receive, such as a tax refund, can also be deposited into the account as an additional repayment which contributes to reducing the interest payable.
- Another possible way to manage the loan effectively may be to set repayment amounts above the specified amount as part of your regular fortnightly or monthly budgets. This limits the tendency to use more of the funds without thinking of the financial ramifications.
- Always remain conscious of the original estimated value of your home that the approved loan amount was based upon. If property values in your area or those within the property market in general are not increasing, be prudent in your use of the line of credit loan so your home equity still remains a comfortable proportion of the total value of your home, against the size of the outstanding loan amount.
What should I be aware of with these loans?
As with every loan, it’s worth evaluating not only the benefits of the loan but also the potential risks, such as the high interest rate attached to these loans compared to other more traditional loans.
Some tips to consider:
- Remember that this loan is most suited to those who are financially disciplined and remain committed to making regular repayments and gradually reducing the loan.
- This may not be an appropriate solution for those borrowers who see the loan as a quick fix to a funding shortfall. Those borrowers may find they are still overstretched financially and then have continual problems with their repayment schedule.
- You need a good credit rating to apply for these loans, so before you submit any applications, check your rating and determine whether you can do anything to improve it. The better it is, the greater the likelihood you'll have of being offered a lower interest rate.
- As with a standard variable loan, the interest rate on a line of credit loan is vulnerable to the overall market movements of the interest rate environment. Ensure you have a realistic financial buffer in place with the loan to cushion the impact of any series of interest rate rises.
- Some lenders may also charge monthly or annual fees as well as application fees, valuation fees and discharge fees, so you need to factor all costs into your financial calculations when comparing line of credit loans from a range of different lenders.
- As with more traditional loans, if a line of credit loan isn't repaid according to the terms of the contract, the lender may be able to seize your property in order to recoup the debt.
Line of credit loans are offered by most banks, credit unions and financial institutions and can be a valuable way of supporting you to manage your finances throughout stages of your life where you require some flexibility as you continue to work towards your goals.
However, with an increasing number of loans to choose from, comprehensive research remains the key to determining which loan will be most appropriate for you and your particular circumstances.