There are many different variations on mortgages and home loans out there for you to choose from, but two kinds which have some distinct differences are a regular mortgage and a line of credit (also known as a home equity loan). Just before I bought my first home a few years ago, I got a tip that a line of credit might be the right kind of loan for me. If you want to know if it’s right for you too, then read on.
What exactly is a line of credit?
Sometimes it’s hard to understand exactly what a line of credit or home equity loan is, but I like to explain that it’s like a really big credit card. In other words, you might get a line of credit for $300,000 when you buy a home – that is, you start off with an account which is $300,000 in debit. Usually, you would arrange to have your salary or other income paid into this account, as well as use it for some regular expenses (I use mine to EFTPOS my groceries at the supermarket, and pay my bills). So the balance might go down or up, although usually you’d aim to have it go down. At the end of the month, the bank calculates an amount of interest you have to pay based on the daily balances over that month, with the interest rate similar to a regular mortgage rate.
One of the advantages (or not, depending on your financial habits) of this line of credit account is that you can easily pay more off your house whenever you want – say you inherited $50,000, you can put this straight into your home equity loan, and consquently your interest payment at the end of the month will drop significantly. However, if you then decide you want to spend $20,000 of this on a car, you can just as easily take it out again – it’s a little like giving yourself a car loan, but at a cheaper interest rate. Another advantage is that, if you compare to a standard mortgage where you make fixed repayments over a period of 20 or 30 years, it is possible to save many thousands of dollars in interest payments.
Beware: A home equity loan is not for everyone
However, I think these loans should come with a big warning. You could save thousands of dollars, or you could end up in greater debt. It all depends on how controlled you are about using your money. For example, if you’ve paid off $20,000 of your equity loan, you might fall into one of two camps of people: those who are happy that their interest repayments are now significantly lower, or those who think that they now “have” $20,000 they can go off and spend on a holiday or a luxury item. In other words, the flexibility of a line of credit can be both a help and a hindrance, and it depends if you can really trust yourself to use the equity wisely or not.
If you’re not sure, then think really hard before you jump in. Many regular mortgage products today have some similar advantages – you can make extra payments without penalty, some lenders allow you to redraw these when you need, and so on. They’re not quite as flexible as a line of credit, but if it helps you to leave the money in the bank, then it’s worth skipping the flexibility. Personally, I’ve had great experiences with home equity loans, and I know I’ve saved a heap of cash by using them – but they’re not for everybody.