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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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.