Do you need a line of credit?
There's an old saying 'you get what you pay for'.
But there's another saying - 'sometimes things are not quite what they seem'.
When competition started hotting up in the 1990s, established lenders responded
to new low cost competition with 'basic' products that were stripped of their
features. You could get a lower rate, but you couldn't pay the loan off. After
another round of competition, established lenders were losing too much business,
so they allowed borrowers to pay their loans off at a faster rate, but then
they stopped them redrawing the additional funds they'd paid off.
Today things have improved still further. In fact the most important flexibility
feature - the ability to make early repayments and then access them by way
of 'redraw' is pretty standard even on most 'basic variable' loans though
fees are usually charged for a redraw.
Other features which remain in the 'luxury' class are
The first of these - and some ways to get the benefits but avoid the costs
of this luxury were discussed on our website in our
first newsletter.
And there are now 'basic variable' interest only options.
What is a line of credit? It is a capacity to borrow up to a certain amount
(with the lender usually holding a mortgage against your house). Lets say
it is for $250,000. Such a line of credit would bear a given interest rate
and may have application and or monthly fees, but so long as the line of credit
is not fully drawn - lets say the lender has drawn on it to the tune of $200,000
then the outstanding amount is always available - usually by cheque account
if the borrower desires to have one.
Further with most lines of credit, you never need to 'make repayments' on
a line of credit while it is not fully drawn. In case you're thinking that
lenders have become Father Christmas let me explain. They do charge interest
- but it is 'capitalised' into your loan so if interest for the month and
any other costs like monthly fees are - say - $1,000, the borrowing on your
line of credit is simply increased by that amount. This saves you the hassle
of making sure there's enough money in some other account to pay it.
So a line of credit is a perpetual 'interest only' loan in which costs are
capitalised, rather than necessarily met by payment from an outside account.
Now if you don't qualify for a professional
package, a line of credit usually costs at least .5% more than a 'basic
variable' interest rate. Some of this margin is justified. It actually costs
the lender a little more to supply a line of credit. Apart from more frequent
transactions on the facility, it does not get 'paid off' over time and so
the risk to the lender is a little higher. But no higher than an interest
only loan and interest only loans are now available for only a little higher
interest rate than a basic variable rate.
But the main reason you'll pay more for a line of credit is - you guessed
it - it's what the market will bear! Lenders reckon that if you're after a
line of credit you will pay more.
Is there anything you can do about this? If you want a line of credit over
$150,000 we can point you towards slightly discounted products under one lender's
'professional package' which gives
you a very small discount on their line of credit. Another 'professional package'
will give you a substantial discount - .5% or more - if your loan is over
$150,000 and your income is over $60,000 per annum - or $100,000 for a couple
(including rent or dividends from investments). This is a very worthwhile
option for those who can qualify.
For those who can't there are other options. There's nothing wrong with
using the redraw facilities on a basic variable loan. This will usually
cost between $15 and $50, but if your loan is $250,000 the interest difference
between a basic variable loan and full blown line of credit will be over $1,000
per year. So if you only make a redraw a few times a year, you're way ahead.
And remember, if you're thinking you want to make redraws more often, you
can make a larger redraw and deposit the money into a high interest rate account.
What do you do about the fact that the loan gradually ticks down - that
you gradually pay it back over the term of the loan? Firstly, don't worry
about it too much. You pay very little off a loan in the early years. For
instance, if your loan is 30 years you've paid off less than 6% of it after
5 years. By that time your house is very likely to have appreciated considerably
and you can then refinance to get a larger loan.
Remember you'd be doing the same even if you had a line of credit,
as you'd want to access the additional equity produced by your increasing
house price. And don't forget, by then the market will be even more competitive
than it is now - you might be able to pick up a line of credit at a discounted
interest rate - or your income may have risen and you can qualify for a really
good professional package.
And for those with good assets and income, there's another way to get around
the obligation to pay principal off in a 'basic variable' loan. Just borrow
quite a bit more than you need, and then pay the excess back into the loan
- to be available for redraw in future. At current interest rates, if you
want to have $250,000 available to you for 5 years, you can do so with a basic
variable loan of $265,000 repaid over 30 years. In five years time your principal
repayments will still leave you with a loan of $250,000. If you still need
to borrow this amount for a few more years, or want to increase it, it's time
to refinance.
The other alternative is a basic variable interest only loan. This avoids
principal repayments for the first five years with redraw access to your funds,
though the basic variable rate on interest only loans is a little above that
on principal and interest loans - usually about 0.1% which is still pretty
good value.
Of course what's been proposed can be a little more cumbersome, so some people
will avoid it. Rather than writing a cheque, a redraw requires a fax to the
lender and the payment of a fee. But it’s just as good a standby if you want
to get your house painted, or add an extension to your house, or put a deposit
down on another house sometime in the future. You can even write the cheque
at the auction. And when you get home or back to work you can fax the money
into your account! No-one knows you don’t have a line of credit - except you
and your lender - and you're a little richer and your lender is a little poorer
than you each would otherwise be.
Cheers
AKA Nicholas Gruen
July 2002
Please note: The observations made here are general and indicative.
Nicholas Gruen is not a qualified investment adviser. Further his comments
are general and do not take into account your specific circumstances. Nor
are they warranted as free from error in any respect whatsoever. You should
not rely on any aspect of them without taking independent financial advice
relating to your own specific circumstances. We suggest you obtain advice
on a fee for service basis rather than from someone who earns either up-front
or trailing commissions from investments they recommend. We would be happy
to let you know of service providers who provide advice on this basis.
|
