Line of Credit

A line of credit is one of the most misunderstood home loan products in the market. On the one hand this type of facility can be of great assistance to a borrower looking to manage debt and pay off a home loan faster and on the other hand is a great tool for investors who are looking for interest only products to maximise their tax deductibility in respect of investment properties.

A line of credit is one of the most misunderstood home loan products in the market. On the one hand this type of facility can be of great assistance to a borrower looking to manage debt and pay off a home loan faster and on the other hand is a great tool for investors who are looking for interest only products to maximise their tax deductibility in respect of investment properties.

What is a line of credit?

The easiest way to explain the answer this question is to imagine that your home loan is really a credit card with a very large limit. It is a loan facility which only requires you to make interest only payments on the outstanding balance at the end of every month.

Here's an example. Say you purchase an investment property for $500,000 and need a loan of $300,000. Let's also assume that you have a fairly good income and can easily afford the loan repayments and more. After talking to your financial adviser and accountant you decide to take the loan as a line of credit.

A line of credit is only available for loans up to 80% of the value of the property, in this case $400,000, and this is what you opt for. When the loan is approved you have a credit facility of $400,000 but you only need $300,000 on settlement. This leaves you with $100,000 unused credit.

So at the end of the day it looks like this:

Line of credit approved up to 80% of the property value. In this case $400,000.

Amount used to settle the purchase $300,000.

Available credit not yet used $100,000.

If you do not use any more credit, the loan balance will remain at $300,000 and it is on this basis that the bank will calculate the interest payable at the end of every month. For example if the interest rate was 7.5% the minimum monthly payment would be $1875 ($300,000 x 7.5% = $22,500 per annum or $1875 per month).

At this stage you're probably wondering why the borrower wouldn't simply ask for an interest only loan in the first place. After all, the situation is exactly the same.

At this stage you're probably wondering why the borrower wouldn't simply ask for an interest only loan in the first place. After all, the situation is exactly the same.

But, the trick here is that there is $100,000 unused credit and this can be used by the borrower for any purpose at any time. This could be used for any purpose whatsoever; in fact it can even be used to make interest payments if necessary. The point is it is a preapproved credit limit meaning that you do not have to go back to the bank to get another loan; you can simply use the line of credit anytime you wish, and you only have to pay for what you use.

It's the ‘only paying for what you use’ part that is the most attractive aspects of a line of credit. It gives you flexibility to spend what you like when you like and to manage your repayments by only having to pay the interest every month.

You still have the option of paying as much as you wish into the loan to reduce the overall limit, so that if you receive a windfall of some sort you can put it all into the loan account, reduce the balance and pay less interest, but retain the right to take the money out whenever you wish.

The only rule is you can only withdraw money up to the approved limit, in the above case, $400,000.

Now that you have seen how a line of credit can be used for an investment property or to manage your money for future borrowing without having to go back to the bank, it's time to examine how you can use a line of credit to pay your loan off sooner.

Of course, the following technique will not work for every person and you need to seek specialist professional advice to make sure this strategy will work for you.

How you can use one of credit to pay your home loan off sooner.

The secret to this method is to make sure you have a strict budget that you can live with. In doing the budget you have to establish exactly how much you are able to spend each month on living expenses and not spend even one cent more!

We will use the above example again to demonstrate how it works.

At the start of the month you receive your income and deposited into your line of credit. Then you use your credit card to pay for all of your budgeted monthly expenses. At the end of the month interest is charged on the remaining balance in your loan account. At the beginning of the month you receive your income again with which you pay out the balance of the credit card from the previous month and deposit the rest into your line of credit. The result is as follows:

Balance
Line of credit limit: $400,000 $300,000
Net monthly income: $6000 $294,000
Budgeted monthly expenses: $3000
Interest charged on account at end of month: $1764 $295,764
Pay Credit Card $3000 $298,764

Over the month the loan balance has decreased by $1,236 a far cry from the balance that would have been the case on a standard principal and interest loan where the balance after one month when making standard monthly repayments would have been $299,754.09

Copyright © 2010 - Homeloans Central. All rights reserved. Web Design & SEO by Web Profits.