Every so often I am approached by my clients for a Line of Credit drawn on their home, or expressed in more technical terms, drawn on their home’s available equity. Although they have heard about Lines of Credit, they are not quite sure what they are and how they work. That is where a mortgage broker comes in handy with advice and a lending strategy for you and your family.
A Line of Credit is a contract with a bank or another lender. The arrangement describes the maximum amount of funds a borrower can draw on the Line of Credit at any time without exceeding the maximum amount. A lender may want to secure the Line of Credit against the equity in your home, thus the Home Equity Line of Credit. The security of real property provides the lender with strong collateral for the arrangement in case the borrower is unable or not willing to pay back the funds drawn on the Home Equity Line of Credit.
Typically, these types of arrangements are used for individuals, who do not have a predictable income stream such as someone who is self-employed. In such a case income can fluctuate from month to month. A Home Equity Line of Credit is the perfect vehicle to secure cash-flow at a very low interest rate, and with the advantage of only having to pay interest on the balance drawn rather than the full amount of a conventional bank loan. The full amount or any balance of it is available at any time the borrower needs the funds.
Lenders will offer Lines of Credit at the bank’s prime rate plus one quarter percentage point or if you are deemed an higher risk an additional one percentage point on top of the bank’s prime rate.
The loan amount established is based on the available equity in your home. If you are mortgage free, yet have unpredictable cash-flow throughout the year, a Home Equity Line of Credit may be readily available to 65% of the property value at the time of contract negotiation. An experienced mortgage broker will be able to find you an even higher Loan to Value ratio exceeding 65%.
If you have a current mortgage, yet, need a Home Equity Line of Credit, a mortgage broker can help you to make an arrangement with a lender and secure a Line of Credit for you as a second mortgage up to 70% or 75% total Loan to Value, meaning the total amount of first and new second mortgage as compared to the current market value of your property.
The Rule of Thumb here is that the closer the agreed upon maximum amount of the Home Equity Line of Credit approaches the 100% mark, the higher the interest rate becomes, because the risk of the lender increases proportionally.
Should you find yourself in a situation where you have accumulated high balances on your credit cards and are carrying high interest rates, needing a new vehicle, perhaps even have a line of unsecured debt, yet you are working hard, but have unpredictable income streams, consider the following:
Consolidate the current debt under an Home Equity Line of Credit umbrella. This arrangement can have a fixed and a variable portion meaning that your current debt balance can be secured at a fixed rate, which can be less than the bank’s prime rate, and in addition secure a variable portion for future cash-flow needs.
Your variable portion of the Home Equity Line of Credit can be used as a flexible account for repayment amounts at any time and if money is required to pay off new credit balances, it is much cheaper to draw from the Home Line of Credit to do so, than to carry expensive credit card balances.
As a side effect of your debt consolidation efforts, you will be able to improve your credit score by paying down short term credit card balances and converting them into one long-term debt commitment.
Also consider to use a Home Equity Line of Credit for automobile purchases and financing rates, which can come at a much lower interest rate than what may be charged to you at the average car lot.
Buyer Beware: A Home Equity Line of Credit does take a lot of personal spending discipline and judgement of your personal spending habits in general. Remember that you eventually will have to pay back the borrowed funds and that a Home Equity Line of Credit is a vehicle of financing, and not a lifestyle.