Home equity line of credit

Thinking of taking out a loan? A home equity line of credit can save you thousands.

Home equity line of credit

A home equity line of credit allows you to access large sums of cash, and by using your house as surety for the loan, you can save a lot of money. We discuss how it all works and how it compares to other types of loans.

What is a home equity line of credit?

A line of credit is similar to using a credit card. The lender sets a maximum limit, and you can borrow as much as you need, up to that limit. You are charged interest on the amount you use, and there may be fees involved.

A home equity line of credit is secured by a property, making it less risky for the lender. If you default, they can sell the property to recoup their losses. For this reason, they are willing to lend you more, at a lower interest rate, and with more flexible payments.

How much can I borrow using a home equity line of credit?

Equity is the portion of your home that you own. If you are still paying off a mortgage and you owe the lender 40% of the current value of your home, then your equity is 60%.

Lenders won’t allow you to borrow against all of this equity, because it’s too risky for them. Instead, most will insist that you keep 20% untouched and unhampered by loans. Some will reduce that buffer to 5% as long as you pay for lender’s mortgage insurance to mitigate their risk.

It’s also important to note that a home equity line of credit can have a minimum approval limit. For example, the lender may refuse to issue a line of credit under $20k. Once you are approved for $20k, you can draw the money out as you need it.

How do the interest and repayments work on a home equity line of credit?

Even though the lender approves you for a large sum, you only pay interest on the amount you use.

Some lenders will insist you pay off the interest owed every month. Others will let you capitalise the interest, that is to say, they’ll keep adding the interest to your loan amount until you reach the pre-approved limit.

Many lenders set up a home equity line of credit account which works similar to a regular bank account. You can deposit your income into it as payment against your loan, and withdraw funds from it whenever you need.

No matter which payment method you use, it’s important to remember that you will still have to pay off the principle and all the interest eventually.

What are the fees on a home equity line of credit?

As with most mortgage products, you can be charged an application fee of $150 – $600 when you apply for a home equity line of credit. You may also need to pay to have your home appraised. Many lenders also charge an ongoing fee of around $10 per month.

Pros and cons of a home equity line of credit

PROS

Flexible withdrawals

Draw funds as and when you need them. If you deposit your income into a home equity line of credit account, you can reduce the value of your loan, and the interest costs, until you are ready to use the money.

Flexible repayments

You can manage the size and the timing of your repayments. You may also be able to capitalise them.

Save money by consolidating

Because interest rates are lower than a credit card or personal loan, you could potentially consolidate your high-interest debt to a home equity line of credit, and save on interest costs.

Suitable for large expenses

With high borrowing limits, a home equity line of credit allows you to access big lump sums that you can use to renovate or invest elsewhere.

CONS

Requires discipline

With a long loan term, accessible funds, and no regular repayments required, a home equity line of credit can be risky for impulsive spenders, who can overstretch themselves financially.

Interest can add up quickly

If you capitalise the interest, it will compound, and your debt will grow very quickly. If you make interest-only repayments and don’t repay the principal, in the long run, your interest costs will be very expensive.

Strict rules for approval

The lender will ask you how you intend to pay off the home equity line of credit, and in what time frame. They may also ask how you intended to use the funds.

Cancelled at lender’s discretion

Some lenders have a clause in the contract that allows them to reduce or cancel your home equity line of credit at any time, which means you may need to repay a large sum at short notice.

Alternatives to a home equity line of credit

Below, we explain the differences between a home equity line of credit and other types of loans, to help you weigh up your options.

Home equity line of credit vs mortgage redraw

Interest:

  • When you redraw funds from an existing home loan, the interest charged is the same as the mortgage.
  • A home equity line of credit usually has a 1-2% higher interest rate than a standard mortgage.
 

Fees:

  • You may be charged a fee when you apply for a redraw.
  • A home equity line of credit will also have an initial start-up fee, but will also usually have ongoing fees.
 

Flexibility:

  • Each time you make a redraw, you may require paperwork and approval from the lender.
  • Once a home-equity line of credit is established, you can withdraw money whenever you need it.

Home equity line of credit vs offset account

Interest:

  • Money drawn from an offset account is charged interest at your mortgage rate.
  • A home equity line of credit interest rate is usually 1-2% higher than a typical mortgage.

Home equity line of credit vs personal loan

Duration:

  • A personal loan comes with a set term, usually up to 5 years. You must repay the loan during this time.
  • A home equity line of credit doesn’t always have a set term. Some lenders will require you pay the line of credit by the end of your mortgage, which can be up to 30 years.
 

Interest rates:

  • Personal loans give you the option of a variable or fixed interest rate. As soon as you take the loan, you start accruing interest on the whole loan amount.
  • Home equity lines of credit usually only offer a variable interest rate, and you only pay interest on the amount you use, not the amount you’re approved for. The interest on a home equity line of credit is around half the rate of a personal loan.
  • Personal loan interest rates will usually be siginificantly higher
 

Repayments:

  • Personal loans have strict principal-and-interest repayments which need to be paid monthly.
  • Home equity lines of credit allow interest-only repayments which can be capitalised.

Home equity line of credit vs a credit card

Interest:

  • Credit card interest rates are much more expensive than a home equity line of credit.
  • However, a home equity line of credit doesn’t offer interest-free periods like credit cards do.

Extras:

  • Credit cards often have rewards attached that are not available on a home equity line of credit.

Repayments:

  • Credit cards have strict minimum repayments which need to be paid monthly.
  • A home equity line of credit may allow repayments to be capitalised.

Borrowing limits:

  • Home equity lines of credit usually offer much higher borrowing limits than credit cards, making it easier to cover large expenses.