Home Mortgages How Does A Line Of Credit Work?

How Does A Line Of Credit Work?

written by Shelley Marsh 07/11/2013
Line of Credit

Quite often people are offered a line of credit when they go to take out their mortgage.  But what is it?  A line of credit or home equity loan is a loan against the value of your house but unlike a mortgage which must be used to purchase your home, a line of credit can be spent on anything.  A line of credit can be spent in one hit or a little bit at a time.  Interest is calculated on the outstanding balance and you only have to pay the interest every month, that is it is an interest only loan.  Having a line of credit is a bit like having a blank cheque book against the value of your home.

Yippeee I hear you say, it sounds like fun but be cautious.  As the saying goes ‘with great freedom comes great responsibility’ and the same is definitely true of a line of credit.  You see when using a line of credit you are adding to your overall debt levels and extending out the time it will take you to pay off your mortgage and own your own home.  The freedom that a line of credit gives you to spend it on whatever you want is a double edged sword.  We have a line of credit against our house, but my personal philosophy is to use it only on things that will make us money and cover the cost of the interest we are paying on the loan.  So our case, we use our line of credit to invest in the stock market.  Now I am in no way recommending this is as a strategy for everyone and the risks involved in borrowing to invest is a whole other blog post.  However, using our philosophy, other things that I could see us using a line of credit for include things like renovating our house (where the renovation adds more to the value of our house than the interest costs) or using it to buy an investment property (not that I like property right now).  These things all represent investments where, if we were forced to sell to repay the loan, the line of credit loan amount should be covered.

Things that I wouldn’t use our line of credit for include things like holidays, clothes, bills or buying a car.  The problem with these things is if you need to sell them to repay the loan they are either unsellable or worth a lot less than what you brought them for.  Some people use a line of credit for debt consolidation, which depending on your circumstances can be a valid strategy.  In this case you need to be committed to paying it off as fast as possible, then closing the loan to avoid the temptation to rack up more debt.

A line of credit can add some complexity to your mortgage and like most things in the finance world, whether a line of credit is right for you is a very personal thing.  Used wisely they can be a great tool to help build your wealth but used poorly they can land you in more debt.  To use a line of credit wisely you need strong financial discipline and good budgeting skills.  If you are tempted by spur of the minute purchases then it is likely that a line of credit is not for you.  Be careful and seek good financial advice before taking the plunge.

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Disclaimer:

The information contained in this post is general in nature and does not constitute financial advice.  Please see your financial advisor for advice specific to your individual circumstances.

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16 comments

Mums Take Five 08/11/2013 at 8:35 am

Good advice. Line of credit is not for new shoes 🙂 Can’t say i’d be keen to use it.

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Shelley Marsh 09/11/2013 at 12:26 pm

Hi Bel! I love it – a line of credit is not for new shoes! That is now my most favourite line, do you mind if I steal it?

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Renee 08/11/2013 at 9:58 am

Shelley, thank you so much for this post. It has brought some clarity to my questions. I don’t think it is quite right for us, but I’ll definitely talk it through with hubby. Thanks again!

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Shelley Marsh 09/11/2013 at 12:28 pm

No worries Renee, it is definitely something worth thinking about and discussing with your hubby further.

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Eleise 08/11/2013 at 10:45 am

I could see how a line of credit would be useful if you were building a new house but other than that, no way! Great article!

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Shelley Marsh 09/11/2013 at 12:28 pm

Hi Eleise, glad you liked it. Thanks for stopping by.

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Alison @ The Thrifty Issue 08/11/2013 at 11:58 am

Thanks for clarifying Money Mummy. We have a ‘construction loan’ which I think was another name for ‘line of credit’ which we took when doing renovations on our house. We used the equity from our home to get this construction loan which has the same interest and terms as our existing home loan. It was great because we could pay the builder, and also go and buy bits and pieces for the house without having to get approval and cheques from the bank every step of the way. Cheers, Al

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Emily @ Have A Laugh On Me 08/11/2013 at 9:25 pm

We weren’t offered this but we had to apply to get extend mortgage to buy a car after ours died. My biggest worry now is hubby might lose job soon, do they still do holiday periods for mortgages? Eg 3 months without paying?

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Shelley Marsh 09/11/2013 at 12:35 pm

Hi Emily, some loans have holiday period, it depends on how your loan is structured. I would ring your lender and explain your possible situation and ask what your options would be given your current loan. They should give you some options and hopefully that will give you some peace of mind during this unsettling period. My fingers are crossed for you that everything turns out well. I lost my job last year so I totally understand what a difficult time it is. xox

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Emily Morgan 08/11/2013 at 10:28 pm

I have to say I’ve never been attracted to lines of credit as they have that feeling of making yourself even further in debt to the bank. Great post as always!

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Shelley Marsh 09/11/2013 at 12:37 pm

Hi Emily, I agree totally. Unless you use a line of credit wisely it can land you in further trouble and at the end of the day you are playing with your family home which means you have to be super careful!

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Seana - Sydney, Kids, Food + Travel 09/11/2013 at 12:04 pm

Hello, that’s interesting. Using the mortgage to buy things is a good plan if there’s fiscal discipline in the household. My husband is very sensible, sensible enough for both of us luckily. I’m startled at how daft some friends have been… huge mortgages at 50 and fast cars… gulp.

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Shelley Marsh 09/11/2013 at 12:39 pm

Hi Seana, yes big mortgages scare me no end! I could not live with that much stress!

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Danya Banya 21/11/2013 at 10:58 pm

Great tips. We’re ‘lucky’ in that we live quite frugally, well under our income levels. I would still get a line of credit though because it’s good to secure a low interest source of money while it’s being offered in case something unforeseen happened and we needed to access it quickly….

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Home Equity Line Of Credit 03/12/2013 at 6:00 pm

Great article. Home equity lines of credit are great but people ought to be careful how it’s used and when it’s repaid. But interest rates are usually much better then using a credit card

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How To Finance Your Home Renovations 06/08/2014 at 6:19 am

[…] on a home equity loan or line of credit are generally slightly higher than mortgage rates.  Click here to find out more about home equity loans or lines of […]

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