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In the last couple of weeks, we addressed How to Use Credit Cards Effectively and whether a Debt Transfer Credit Card, Good or Bad? After looking at what many believe to be the most evil form of credit, we’ll look into what I consider to be a heavily abused credit facility: a personal line of credit.
Types of Personal Lines of Credit and How do They Work
There are several types of personal lines of credit, home equity, those connected to your chequing account, stand-alone lines offered by your bank or credit union and those offered third parties (often credit card companies). Once again, before explaining each of these, I’ll stress the importance of reading the fine print. Covering them in the order of magnitude, we’ll start with a Home Equity Line of Credit (HELO). They are offered in two manners, instead of a mortgage (which is repaid over the amortization period), your entire debt associated with your home is a line of credit. This can be an excellent options for entrepreneurs, executives and professionals with access to significant variable compensation so they can pay off as much debt as possible with a prepayment charge (penalty). When a business or investment opportunity appears, they can borrow from the HELO without asking the bank, very flexible. The other option is a HELO with a mortgage attached. Let’s say you borrow $200k again the security of your home. You can have a mortgage for a portion and a line of credit for the balance. As you pay off the mortgage over time, your available credit in the HELO goes up. I would recommend this option to anyone and everyone who can qualify for it. The HUGE advantage of of home equity line of credit, they have the lowest interest rate of all the revolving credit facilities because they are guaranteed against the value of your home.
You may have a line of credit from your financial institution. It is important to understand it features. Some are connected to your chequing account. When you need cash and the account is empty, the money is borrowed from the credit line. If you have a debt balance and you deposit money into your chequing account, it is used to pay back the credit facility. This is the second best option. In this way you only borrow as much as you need and cannot forget to repay the debt. The last two are similar but function somewhat differently, when you need to borrow money, you borrow from the line of credit by transferring or writing a cheque to your account or wherever you are making payment.
How to Use a Personal Line of Credit Effectively
A line of credit is a revolving facility which allows the borrower to apply for an authorized amount, the credit limit, with a variable interest rate, normally tied to the financial institutions prime lending rate. Once the line of credit is in place, the consumer can borrow from and repay the facility as they wish. A HELO offers the lowest interest rate and is kept in place as long as you own your home. Be sure to pay off the capital you borrowed over time. The only reason to have the entire loan in a HELO is that you can afford and will make large lump sum payments on a regular basis, monthly or quarterly. Many institutions allow for annual payments of 10-15% on their mortgages. If you are not a homeowner or do not qualify for a HELO and have the choice, go for a line of credit that is connected to your chequing account. Be sure to pay off your credit card in full every month. You will still need to keep track of your revenues versus expenses and will likely pay less interest for your debts on a monthly basis. If this is not available from your bank, then a personal line of credit can still be advantageous, you just have to make sure to pay the money back at least once or twice a month (usually the day after you get paid). Last tip: the higher the credit limit, the lower the interest rate. So when negotiating rates, and you must do this, with the bank, take the highest limit for which you qualify!
Dangers Involved With a Personal Line of Credit
Remember I mentioned that I consider personal lines of credit to be heavily abused credit facilities, here is why. Many people thought it was a great idea to rent their homes from the bank. With a HELO, it is possible to pay interest only on the debt related to your home. In this manner you will contribute to the profits of the bank on a monthly basis forever. If some unforeseen circumstance happens, loss of job, property values decrease, a recession, crisis in the banking industry, any of this sound familiar?, and BANG! You many end up giving back the keys and affecting your credit. The danger with a personal line of credit linked to your chequing account is you many choose to ignore the difference between your income and expenses. If you are consistently spending more than you earn, you will reach the edge of the cliff. Many people in this predicament then turn to credit cards next, definitely a bad idea, remember credit cards can be EVIL. A credit line not connected to your account is often forgotten and the interest paid is considered a small debt payment. The problem is that you never pay off the debt. As far a third party lines are concerned, I have me many clients over the years that have seen their lines of credit transformed into personal loans, with little warning. All with significant interest rate increases. Remember I suggested you read the fine print, they make it easy to borrow and then they cash in!
As is the case with a debt transfer credit card, if you don’t have a plan to pay off your personal line of credit, look out! And while the volume of credit card holders who don’t pay off their balance in full every month is staggering, I’ll bet that the $$$ paid in interest paid on personal lines of credit would boggle the mind.
Do have a personal line of credit? How do you use it and do you have any tips to share?
Next time around, I’ll discuss mortgage.
Author: Robert
I have a personal line of credit. Currently, I have a zero balance. I use it for short term necessities only. Short term is up to a year, but in my case I usually pay it off the next month.