How does a line of credit work?

How does a line of credit work?

The ‘Line of Credit’ loan has been created to give you maximum control over your equity. The idea is very similar to the credit card system where the bank makes available to you a maximum amount of funds. You are liable for the interest on a monthly basis and this interest is calculated only on the running balance, NOT on the limit of the account.

As an example, let’s say that you had a property valued at $400,000. You would be able to obtain a Line of Credit secured against your property – as a guide we will use a Loan to Value ratio of 80% - of $320,000. If your mortgage balance is $150,000 then you only pay interest on this amount which, if we had an interest rate of 6% would mean a monthly interest bill of $750.

If in the following month you needed $100,000 to purchase investments, you would be able to draw down this sum without asking the permission of the bank as there already would be $170,000 of available funds in your line of credit (Limit of $320,000 less current balance of $150,000 equals $170,000 available). So you would use the $100,000 needed which would bring your balance to $250,000… your interest for the month would then become $1,250 and you would still have $70,000 left available in your account.

This is the ultimate in control for you as you empower yourself to become the manager of your own funds. Of course it is important to note that if the funds are used for the purchase of depreciating assets such as cars, boats, holidays and the like you might find yourself going backwards in your wealth creation journey… Just like you would with a credit card.

You can also use the line of credit to pay off your home loan much sooner than you would with a principal and interest loan. The interest component is calculated on a daily basis and then charged to you at the end of the month, this means that if you can reduce your balance even for only one day of the month you will pay less interest… You can use your line of credit as your main transaction account and park all of your income – wages, commission, savings, etc – to reduce your interest bill. This can have a compounding effect over time reducing the time you need to pay off your mortgage dramatically saving you years and thousands of dollars in interest. You can further improve this, using investments such as shares and property to drive even more income into your line of credit. Of course it is your situation, your motivation and your financial circumstances that will determine how fast you can achieve a debt free home.

To keep control of your equity, as the value of your property increases, it is usually easy to have the limit of the line of credit increased rather then having the loan refinanced. This prevents you from paying too many setup fees over the years. Some people have managed to pay their homes off in only a few years which is very far from the 20 -30 years promised by the Banks!