Do you need a line of credit? - Newsletter 2001

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 often charged for a redraw.

Other features which have now become more commons are

• offset accounts

• interest only options and

• lines of credit

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 way back in 2001.

What is a line of credit (LOC)? 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 some 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 may be 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. But not always, we have some lenders offering discounted lines of credit at the same rate as their standard loans.

For those who can't justify an LOC. There's nothing wrong with using the redraw facilities on a basic variable loan.  There are some excellent loans such as the ING Mortgage Simplifier with unlimited free additional repayments and redraws, so 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.

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 if you are an investor 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 which is still pretty good value. 

Of course what's been proposed can be a little more cumbersome, so some people will avoid it. 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 transfer the money into your account!

Cheers


AKA Nicholas Gruen  

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.