Line Of Credit Risks and Rewards
What’s the Best Choice, a HELOC or a line of credit?
Essentially they are one and the same. A HELOC is a Home Equity Line of Credit, which basically means the same as a Line of Credit. That said, there is one subtle difference in that a HELOC is secured by the equity in your home.
Whereas a Line of Credit doesn’t necessarily have to be secured by property. Some Lines of Credit can be business LOC’s, much like a business overdraft. However, with this article we’re going to be focusing on the Home Equity Line of Credit.
Essentially, what is a home equity line of credit?
How can you use one successfully? A line of credit (LOC) is a loan option that allows you to have an upfront approved cash credit limit that you can access at any time. There are no interest charges on the credit limit you are approved for only on the amount you have drawn down on, or the outstanding unpaid balance.
It operates much like your own bank account. Except the money you have access to is not really yours and whatever you use you’ll be charged interest on it. You can spend the money on whatever you like as long as you don’t exceed the approved limit.
You can take money out, pay it back and borrow over and over again, simply making sure you don’t go over the limit.
You get a Grace Period
The differential between a credit card and an LOC is, you get a grace period with credit card interest charges, sometimes up to 55 days. There is no grace period with an LOC. An LOC is a borrowing tool not a payment tool, because much like a home mortgage, the moment you take the money the interest charges start accumulating from day one.
A line of credit provides the borrower with a ready source of cash that people use for various reasons. Typically the limit can be set higher than a regular credit card at a lower rate of interest. You don’t have to take out a personal loan that forces you to make payments on the full amount whether you want to use all of it or not.
In other words it provides flexibility to pay what you need to pay when you want to pay it and only pay fees on the drawn balance. Common purposes for a line of credit are to pay school fees, consolidate other debts, do home renovations, holiday money or any other expenses.
You Could Lose Your Home
These days, if the line of credit is secured by your home or other residential property it’s now evolved over time to be tagged as a Home Equity Line of Credit or HELOC.
The major concern associated with home equity lines of credit is you’re putting your home up as security.
Since any type of residential home mortgage lender will want your real estate asset as collateral you’ll want to be very sure that your line of credit doesn’t get out of hand, whereby you become delinquent with your repayments.
Falling behind on repayments and not being able to catch them up will very well put your property in peril of foreclosure.
Don’t Play with Fire Without an Extinguisher
Do your due diligence up front and find out if there are going to be other costs, like settlement costs or loan establishment fees. Some of these products will charge you a fee anytime you make a withdrawal or even a monthly account fee.
Over time these fees can start to add, notably if you’re in the habit of regularly withdrawing cash out.
That said, you really want to avoid using one of these as a personal piggy bank to start paying your everyday living expenses. Should you find yourself with your budget out of whack, then creating more debt isn’t the greatest solution in the world.
No, they’re Really not a Giant Credit Card
Keep in mind, one of these is not like a credit card, although they’re sometimes described as a giant credit card. However, as soon as you draw down on it for any given amount you are immediately charged interest on that amount from day one.
You do have to be careful with one of these and be able to manage your cash flow well, as lines of credit come with interest only repayments and some even allow you to capitalise the interest they’re charging you. That means, you don’t have to make any payments at all (until you reach your approved limit, of course) I’ll leave it up to your imagination as to how big a debt hole you could dig with one of these.
Make sure, for whatever debt you clock up you’ve got an effective plan worked out for paying it back.
Managed well, They’re Handy to Have Around
One of it’s benefits is it can remain in place for years, you can pay the balance down to zero and not pay anything until you have a need for it again. Keep in mind, a lot of lenders will charge you a nominal monthly fee for the privilege of having one.
Although, you should be aware that the usual term and conditions of these types of loan products allow the lender at any time to reduce your credit limit or even call on you to pay any outstanding balance in full.
Now, that’s unlikely to happen if you have been managing the loan with good conduct. Nonetheless, keep that point in mind.
Don’t get Caught Going the Wrong Way in a One-Way Street
Most lines of credit products provide a variable interest rate, which is terrific while interest rates are at historical lows. Nevertheless, I’ve had customers in the past tell me that their LOC or HELOC is going the wrong way, in that they’ve been complacent and allowed themselves to use it for the wrong reasons.
Keep in mind if you allow that limit to keep on rising and then all of a sudden your bank increases your interest rate, where will that end up with your ability to repay them.
I don’t mean to be boring, but seriously there are definite risks associated with lines of credit. Whatever you do, don’t use it as an emergency fund, this is the most common frequent trap I see people get themselves into. At any time, the bank can close it down on you.
These May not Be Right for You
There are other choices besides a line of credit for enabling you to get access to extra cash. For example you can apply to your lender to top up your existing loan for the amount you need.
This is a better option if you need a one off cash injection for home remodelling/renovations, purchase a vehicle, pay a tax bill etc. Once the bank approves you they will adjust your regular repayment amount and you will start paying the debt down.
If you’re doing renovations where the money is paid out incrementally over a period of time, have the lender put the amount you borrowed into your offset account so any remaining balance offsets against your mortgage.
Sexy Maybe, but can You Afford to Have One?
Don’t be lured into the roller coaster of a line of credit where you can be exposed to the temptation of using the money over and over again. It takes a strong willed person to resist putting their hand into the biscuit tin again and again
One more final cautionary word: Fast Cash Lenders (Payday Lenders) and some non-bank (secondary) lenders are now in the market place offering LOC’s with credit limits up to $20,000. Run the other way. when it comes to debt traps, this is the bear trap of all traps, they charge interest rates of 60% plus along with actrocious fees that can force you to get another loan to pay the first one off.