Line of credit mortgages
A line of credit allows you to make the bulk of your purchases or payments through a credit card with an interest free period.
You use the credit card for most purchases allowing you to leave the bulk of your wage in the loan until your credit card account is payable. This slightly reduces the balance of the home loan debt for part of the month and therefore slightly reduces the interest payable. These types of savings are called offset savings.
The credit card will be paid off each month by using your funds from the line of credit. The offset savings achieved for most people will be minimal.
Will you pay your loan off more quickly?
The extent to which you can repay a loan more quickly usually depends to a far greater extent on your capacity to make additional repayments, rather than through offset savings.
Generally, borrowers who cannot afford to make significant additional repayments will be worse off refinancing to a line of credit, because a line of credit will usually have a higher interest rate and the higher interest charges will outweigh any offset savings.
Example
Five questions to ask yourself |
Persuasive charts and graphs
A broker may encourage you to refinance to a line of credit with calculations, charts or graphs showing the balance of your loan being paid off more quickly than your existing loan.
However, these comparisons may involve assumptions that aren't correct, for example that you can afford to make large additional payments or that you're not permitted to make additional repayments under your current loan.
Charts and graphs may be misleading if the broker suggests that the balance you owe is going down more quickly because of some special feature of that loan when in fact it's really happening because you are paying larger amounts off each month.
Who may benefit
Line of credit mortgages are generally interest only loans with no set term for the loan to be repaid. The borrower then has the freedom to choose when they will make payments on the principal, which may suit some borrowers.
Lines of credit may be good for people who have fluctuating incomes and may sometimes be able to make additional payments, but would also at times be unable to meet the normal repayments on a standard loan. They suit people who need a great deal of flexibility and can afford to pay a higher rate of interest.
Example
Chris and Robyn earn a total of $4000 per month. Their expenses are $2000 per month (not including their mortgage repayment). They have an outstanding balance on their loan of $200,000. On their standard mortgage (a variable loan with an interest rate of 6.95%) they are paying $1500 per month.
A broker approached Chris and Robyn and said that they would be able to pay their home loan off years quicker if they:
- transferred their mortgage to a line of credit style mortgage
- deposited their salary straight into their mortgage, and
- utilised a credit card for all their purchases.
The interest rate for the line of credit would be 7.06%
Chris and Robyn made some enquiries and found out that the broker’s calculations relied on them making payments totalling $2000 per month instead of their current repayments of $1500 — an additional repayment of $500 per month.
They also found out that their current home loan would allow them to make extra repayments without penalty. The offset savings they would make by using the line of credit would be less than $150 a year.
Chris and Robyn decided to stay with their current home loan and make extra repayments when they felt that their budget would allow. |
FIDO’s questions to ask yourself about line of credit mortgages
1. Do I really need to refinance?
Most mortgages these days let you make extra repayments. If the main way in which you are saving interest is through extra repayments, you may be able to achieve the same benefit by making those additional repayments on your current loan, without the cost of refinancing to a new loan. However, check whether your current loan allows you to redraw funds if you think you might need to access those funds at any time. Take time to consider your options.
2. Will any savings I make outweigh the fees incurred?
Before you refinance, check that you'll be better off. Line of credit products usually charge higher rates of interest than standard loans, and you may also be charged more in fees. Paying extra in regular interest payments or fees may cost you far more than any savings these features might offer.
When weighing up the costs and benefits of any refinance, make sure you consider whether your current lender will charge you termination or break fees for exiting your loan early. You will also have to pay the lender's legal fees for discharging the mortgage over your property. You also need to consider the cost of application fees, stamp duty, valuation and legal fees. These costs can quickly add up and reduce the value of any benefits from refinancing.
3. Do I have the capacity to make extra repayments?
Make sure you consider carefully whether you can make extra repayments. If you find you have no money left over at the end of each period you probably can't make higher repayments. You may even put yourself in a worse financial position by refinancing.
4. Will I be tempted to overspend?
Line of credit mortgages are generally interest only loans with no set term for the loan to be repaid. This means that the monthly repayments are smaller than on a home loan because you only have to pay the interest and not the principal.
If you think it will be hard not to dip into your line of credit for daily living or luxuries, then a line of credit will not suit you. You might never fully own your home at all and still face a large debt when you retire.
The discipline of a standard home loan where you must make larger regular repayments is useful if you have a tendency to overspend.
5. What other alternatives are there?
If you're thinking about refinancing, don't restrict yourself to comparing your current home loan, with its current level of repayment, and a line of credit loan with higher repayments. Work out what extra repayments you can afford to make, then work out which loan would be most effective. It may be your current loan, a line of credit or another product in the market.
Misleading loan calculators
In 2004, we acted to close down loan calculators on more than 100 websites of Australian financial institutions, including banks, credit unions, other lenders and finance brokers. The calculators suggested that using a line of credit will result in the consumer paying off their home loan more quickly.
No credit for misleading loan calculators
Back to Loans and credit
More help
Buying a home
Types of loans
Mortgage brokers
Paying off a loan sooner
Loans, families and relationship breakdown
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FIDO Website: Printed 07/29/2010
