Puzzle Finance Blog

Return of traditional mortgages

Line-of-credit home loans have proved costly for many borrowers, writes Lesley Parker.

Volatile investment markets and question marks over property values are making line-of-credit loans less popular and potentially harder to unwind for those who have one.

Loan and financial advisers say line-of-credit loans can be a powerful tool when they are used with discipline to pay down a mortgage faster or finance wise investments.

But the danger is that they can also be used as nothing more than a ''massive credit card'' and they can leave people more exposed when things go wrong. 
Depending on the particular product, line-of-credit loans may require only the payment of interest, rather than eating into the debt itself, or even allow interest to go unpaid and be capitalised into the loan, increasing the debt.

They have been marketed as being a more flexible loan - allowing the money to be drawn on for investments such as shares or property - and as a way to quickly extinguish your mortgage by parking income such as wages, rent or dividends there, thereby lowering your daily interest.

But some people find themselves going backwards instead, perhaps because they're not sufficiently disciplined in drawing on the credit or because events such as illness or injury have a greater impact when only interest is being paid on a loan.

The chief executive of financial products researcher RateCity, Damian Smith, says line-of-credit customers may be asked to stump up a deposit of as little as 5 per cent - or even no deposit for wealthier customers - ''and at 5 per cent or less, they are highly susceptible to changes in property values and shocks to their income''.

''If you get sick or lose your job - and job losses are a bigger issue than they were 12 months ago - shocks to your income are an even bigger shock if you owe 95 per cent [of the value of your home] rather than 80 per cent. At 80 per cent, you're in a much better position to cope for a few months,'' he says.

In this situation, people may try to switch to another type of loan and, in theory, that should be no easier or harder - or more costly - than refinancing any other loan.

However, people can be stumped by the fact that they don't have a record of savings or sufficient equity to qualify for a new loan (see case study below), especially in areas where property values have declined, experts say.

''People who bought at the top of the market who are now trying to restructure their borrowings don't have the equity they once had,'' says Hugues Claite, the loans and finance manager for national wealth-management firm Plan B, which has its headquarters in Perth.

The same can apply with falling share values.

Claite says lenders tightened up on line-of-credit loans during the global financial crisis. ''Unless you could prove what you were using the money for, they weren't too happy with providing these facilities,'' he says.

This has continued to some extent and with 100 per cent offset facilities now available, ''people don't really need, or want, to pay a premium for a line-of-credit loan'', he says.

Line-of-credit loans had fallen to 4 per cent of all mortgages as of November - a 13-year low - from a peak of 10 per cent at the end of December 2005.

An executive director of ING Direct, Brett Morgan, says as well as seeing less take-up of line-of-credit loans, the bank is finding existing customers are paying them down quicker.

''That correlates with the overarching trend we've been seeing of households paying down their debts,'' Morgan says. In some cases, the money is coming back from people liquidating investments they made using the line of credit, he says.

In addition, Claite says some clients with line-of-credit loans are sitting on the sidelines waiting for market volatility to reduce before going into geared investments.

The managing director of Australian Mortgage Options, Robert Projeski, says line-of-credit loans can be a powerful tool - but they're not for everybody.

''If you're [the sort of person who is] not disciplined with your credit cards and don't pay them in full [each month], you might want to consider another product as this could be considered as if it's one big credit card,'' he says.

''If you're not a very good manager of your cash flow, you might want to avoid this product as the minimum repayments are interest only and therefore in 25 or 30 years' time, potentially, you could still owe the amount you originally started off with.''

The NSW/ACT and Western Australia state manager for Heritage Bank, Paul Moses, says he ''strongly suggests'' people go through some sort of budgeting process when entering any mortgage contract - but especially this type of loan.

''When you've prepared a budget, it's very important that you execute it well and cater for unexpected expenses,'' Moses says, referring to cash-flow speed bumps such as margin calls in falling markets.

Claite says: ''Any line of credit we consider for a client, we have a really good conversation around discipline. If that discipline is questionable or lacking, we're going to look at a more traditional loan.''

Key points
  • Line-of-credit loans have slightly higher interest rates.
  • Technically, they are no easier or harder to exit than other loan products. However, falling property and investment values may complicate things.
  • A rule of thumb is if you don't pay off your credit card each month, this loan isn't for you.
Couple caught out trying to switch loans

Sandy, of Noosa, who asked not to have her full name used, says a broker recommended a line-of-credit loan some years ago when she and her partner had to relocate interstate.

''The broker advised us this was the only way we could do it,'' she says, of buying their new home. At the time, she was pregnant and her husband was setting up a small business so didn't have a regular pay packet.

The loan was set up, a property bought and the business established. Then her husband had an accident that kept him off work for eight months. The couple found the loan was not reducing at all.

''When we saw it wasn't for us and it wasn't working … we wanted to change to a standard home loan,'' Sandy says. But the catch-22 was that they hadn't built up any equity in their home so they didn't meet the lending criteria for a different loan.

They were stuck with the line-of-credit loan for several years, finally securing a standard loan in 2009.

It's only since then that they've been able to eat into the debt.

The couple remains in dispute with the bank about the loss they say they suffered by not being allowed to switch earlier.

Posted by Lesley Parker - The Age Money on 1st February, 2012 | Comments | Trackbacks

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