Nowadays it’s very common to see various finance publications advise borrowers to utilise a line of credit (LOC) as a way to obtain cash to purchase an investment property or help repay the mortgage on their home. Benefits of using an LOC include convenience and ease of access, but do they provide the best value? Usually not.
There are several different packages investors can opt for that are not only cheaper than LOCs, but offer more features. This article will discuss the problems that arise when using an LOC, and why so many investors are paying much more in interest rates and fees than they ought too.
The difference between an LOC and a regular loan
In some aspects, an LOC and a regular loan have similar characteristics, but there’s also some obvious disparities. They include:
Fully drawn – When a regular loan is settled, the lender immediately gives the total sum to the borrower and they start paying interest from day one, while LOC’s work more like credit cards. For example, if a borrower has an LOC of $50,000 and they withdraw only $10,000, they only pay interest back on the $10,000 withdrawn and not the remainder ($40,000).
Term dates – Most regular loans will have a time limit in place by when the borrower must repay the total amount of the loan (usually 20-30 years). An LOC has no such thing, but lenders can demand the borrower to repay the total LOC taken out within a short period of time.
Certain lenders will run an annual review on their clients LOC accounts to view their history for the past year, and to deem if they are still eligible to carry on with their LOC.
Repayment schedule – Regular loans will have a monthly payment based on the fixed or variable rate. As an LOC has no term dates. They also have no minimum monthly repayment schedule.
Capitalise interest – Any interest amassed by the borrower using an LOC can be added to the overall loan balance. Much like a credit card adds the interest to the total loan balance, an LOC works pretty much in the same way.
Note: Interest will only be added to the loan if the borrower has not overrun their LOC limit.
Merging of accounts – Most LOC products will merge a borrower’s loan account with their current transaction account. Borrowers can use this to deposit their salary and rental income directly into their LOC account and have access to it via ATM, telephone and online banking. LOC products can also be used to pay bills and any other expenses.
Does an LOC cost more?
They sure do. On average the interest rate on an LOC can be as much as 0.50% higher per annum compared to regular loans. Most lenders will not discount LOC interest rates as much as they would with a regular loan. There are two main reasons for this:
Flexibility– All LOCs are extremely flexible and permit the borrower to spend money on whatever they see fit. As mentioned earlier, LOC products include features such as telephone banking, merging accounts and having access to ATMs. Such features come at a cost to the lender and they need to make it back one way or another.
Risk – As the lender has no control over what the borrower spends their money on, the risks associated are much higher. LOC products present lenders a much tougher task to manage their interest rate exposure, as there’s no consistency in how much money is being taken out or paid back each month.
What the experts think
Professionals recommend LOC products for a number of reasons, the two biggest being:
Savings –Finance specialists claim that using an LOC will help save on interest expenses, which in turn helps the borrower pay off their mortgage quicker. Borrowers can save money using an LOC by depositing their monthly salary and rental income into their LOC account. This method allows them to save up to 6% because the money they have deposited reduces the interest rates of their LOC for a few weeks or months (until they require their salary to pay for living costs etc).
Flexibility – This is one of the biggest reasons why financial gurus advise borrowers to go down this route. However, flexibility can also cause problems. Borrowers see large sums of money sitting in their account and they find it too tempting not to spend, so they end up splurging on something they didn’t plan on buying that they cannot later repay back. Before they know it they are in a world of trouble.
Note: LOC products are not suitable for everyone. Borrowers must be disciplined and not reach into their LOC whenever they see fit, thinking they can pay it back later down the line. If you’re the type of person who has trouble in paying their monthly credit card payments, we would strongly advise you to avoid all LOC products.
Why we disagree with the experts
Well, we don’t disagree that LOC products offer savings and flexibility, but what we are concerned with is how much a borrower can realistically save when using an LOC over a regular loan.
From our own personal experience and examining the data we have available, the average borrower will save around 0-5% in interest fees over the course of their LOC. Any surplus of money (salary or rental income) should always be invested into their LOC and have that money ‘work for them’ by reducing interest fees.
As we mentioned earlier, most borrowers will deposit their salary into their LOCs each month and money is drawn out when needed to pay for expenses. Any money that is left over is either withdrawn, invested or left in the LOC as ‘extra repayments’. Given this information, we can safely say the maximum a borrower can save with an LOC is the equivalent of one year’s interest on the borrower’s monthly salary. This is based on the assumption that they deposit their whole salary into their LOC each month.
|Date/Info||Salary of Bob||Balance of LOC|
|Dec 1- Starting Balance
Dec 31- SalaryDec 31 – Expenses paid
Dec 31 – excess withdrawn
Figure.1 shows a better example of what we mean. Bob’s salary is $5,000 per month which he puts directly into his LOC each month. Bob’s lender’s interest rate is set at 6% per annual giving him a yearly saving of $300.
Calculation: Salary x interest rate ( $5,000 x 6% = $300)
Compare this to the interest Bob would pay if he took advantage of his LOC, it would come to $20,000 per year.
Calculation: LOC balance x interest rate ( $500,000 x 6% = $20,000)
Using the data above, Bob is set to make a 1.5% ($300/$20,000) saving which is not really a lot in the grand scheme of things.
Any excess or surplus of cash is considered an ‘extra repayment’ and should not be included in the savings made when using an LOC. Many lenders often group both together to lure borrowers into thinking they will make greater savings. A few lenders have even been slapped on the wrist by the Australian Securities & Investment Commission (ASIC) for implementing such tactics. Extra repayments can be made on almost all loans and is not something unique only to LOC products.
Another common approach used to with an LOC is to combine it with a credit card that offers extended interest-free periods (typically 55 days or more). The credit card is used to pay for expenses and allows the borrower to keep their salary in their LOC account for a much longer period of time. This is based on the assumption that the borrower will always pay off their credit card debit in time. Otherwise, the interest fees associated will be higher than what they would have saved with their LOC. To give you an example, our friend Bob is using his credit card that gives a 60-day interest-free period to pay for his expenses. This allows him to keep his salary in his LOC for an extra three months.
- 1 Month because Bob will not need to pay his expenses until the end of the month
- 2 Months due to the 60-day interest-free limit on Bob’s credit card
This will increase the savings on our pervious calculation from $300 to $900, which is 4.5%. Compare this to a regular loan with an interest rate of less than 0.50%, that would save Bob as much as $2,500 per year, which is 8%.
Calculation: Loan amount x interest rate ($500,000 x 0.50 = $2,500)
Saving divided by interest paid ($2,500/$20,000 = 8%)
These numbers are based on the most a typical scenario. We have been very charitable in assuming Bob will pay his expenses at the end of the month and being able to find a credit card with such a long interest-free period.
Homeowners should opt for offsetting or using a basic variable product
In an ideal world, homeowners should aim to find the cheapest mortgage while paying back as much as they can, when they can. Lenders’ advertising jargon will often mislead borrowers to go for packages such as LOC’s that will end up costing more.
Homeowners who are looking to borrow more than $250,000 should easily be able to find competitive rates by opting for a professional package. This should give them at the least 0.60% lower interest rates than the bog standard lender. Going down this route, homeowners should receive all the benefits they would with a regular LOC while taking advantage of much lower interest rates. For smaller loans (under $250,000) opt for a basic variable loan, homeowners should expect to receive 0.50-0.70% lower interest rates than typical standard variable rates.
Some products will give the borrower the ability to redraw for free (or for a small fee) which is what they want. This will allow borrowers to deposit their monthly salary into their loan account. Appling the interest-free credit card method and by depositing their salary into their loan account, borrowers can offset the costs of their mortgage for two months before using the funds to pay off the credit card debt. This method will provide the biggest possible savings.
Note: Only use an interest-free credit if you’re disciplined and will pay off the balance in full before the interest-free period is up. Some people see credit cards as ‘free money’ and end up going over their limit and facing problems later on.
Investors: Did you know?
An LOC provides investors with a pool of money that they can freely access whenever they need, without paying interest until they withdraw any funds. But do investors know that they can do the same with several basic variable packages?
We stated that most basic variable loans are ‘fully drawn’ and the borrower will receive all the money on day one and start paying interest immediately. While this is true, borrowers can find basic variable loans that offer ‘redraw’ options. For example, Bob has just taken out a basic variable package secured by his home for $200,000. On day one of the loan, Bob receives the total $200,000. On the same day, Bob repays $199,999 of the loan leaving an outstanding balance of $1.
With the redraw option, Bob at a later date can redraw the $199,999 as and when he needs while only paying interest on the outstanding balance of $1.
Note: Some lenders will implement ‘early replacement fee’ clauses in contracts. Before agreeing to any loan it’s important to find out what they are and how they may affect you.
We hope this article has given you a detailed review of LOC’s and other standard variable products. Often the savings made using an LOC are less than what lenders advertise, and result in borrowers overpaying for such packages. However, depending on what you require the money for, you may find them to be more beneficial. As an LOC is certainly more advantageous for investors who are renovating properties and need to make several small withdrawals in a short amount of time.
Don’t be fooled into believing everything the lender tells you as words can often be spun to paint a different picture. Speaking to an expert in the industry for advice is a great place to start your journey, they can point you in the right direction based on your investment plans.
**This information is not intended as advice and should be viewed as general information only.