What is a home equity line of credit?

A home equity line of credit is a form of revolving credit in which your home serves as collateral. Because the home is likely to be a consumer's largest asset, many homeowners use their credit lines only for major items such as education, home improvements, or medical bills and not for day-to-day expenses.

With a home equity line, you will be approved for a specific amount of credit--your credit limit, the maximum amount you may borrow at any one time under the plan. Many lenders set the credit limit on a home equity line by taking a percentage (say, 75 percent) of the home's appraised value and subtracting from that the balance owed on the existing mortgage. For example,In determining your actual credit limit, the lender will also consider your ability to repay, by looking at your income, debts, and other financial obligations as well as your credit history.

Many home equity plans set a fixed period during which you can borrow money, such as 10 years. At the end of this "draw period," you may be allowed to renew the credit line. If your plan does not allow renewals, you will not be able to borrow additional money once the period has ended. Some plans may call for payment in full of any outstanding balance at the end of the period. Others may allow repayment over a fixed period (the "repayment period"), for example, 10 years.

Once approved for a home equity line of credit, you will most likely be able to borrow up to your credit limit whenever you want. Typically, you will use special checks to draw on your line. Under some plans, borrowers can use a credit card or other means to draw on the line.

There may be limitations on how you use the line. Some plans may require you to borrow a minimum amount each time you draw on the line (for example, $300) and to keep a minimum amount outstanding. Some plans may also require that you take an initial advance when the line is set up.

Reserve Bank interest rates explained

The main responsibility of the Reserve Bank of Australia is to formulate and implement Monetary Policy, as laid out in the Reserve Bank Act (also known as the Bank's 'charter'.) The RBA has a duty to ensure that its powers are used solely to advantage the people of Australia by positively contributing to:

1. the stability of the currency of Australia;
2. the maintenance of full employment in Australia; and
3. the economic prosperity and welfare of the people of Australia.

The main objective of the RBA's Monetary Policy is to achieve low and stable inflation over the medium term. To accomplish this, the RBA regularly reviews Australia's interest rates.

The RBA also works to maintain financial system stability and avoid situations that could severely threaten the economic health of the country ; it promotes the safety and efficiency of the payments system and is an active participant in financial markets. Other roles include issuing Australia's currency, acting as banker for the Federal Government and managing Australia's foreign reserves.

Interest rates

Official interest rates are dependant upon how the economy is functioning at any given time. The RBA holds monthly meetings of the Board to determine whether the cash rate should rise, fall or remain stable. Factors considered by the RBA when making this decision include:

• the current inflation rate;
• unemployment;
• the consumer price index (CPI);
• the producer price index (PPI); and
• levels of retail sales.

At times of stable inflation and economic slowing, the RBA might drop the official cash rate to encourage spending. However, if inflation looks set to rise above 3% in the long term, the RBA may attempt to slow things down by raising rates, regardless of the current economic state . The ultimate objective is to encourage long term growth without the severe economic ups and downs seen in past years.

Recent trends in interest rates

From the early 1990s to the end of 1998, the official cash interest rate steadily dropped from around 17.5% to 4.75%. Since December 1998, interest rates have fluctuated between 4.25% and 6.25%.

Since reaching their low of 4.25% in December 2001, official interest rates have been slowly rising, seeing increases of 0.5% in 2002 and 2003, 0.25% in 2005 and 0.5% so far in 2006. A further rate rise of 0.25% has been speculated upon for late 2006.

How does this affect me?

The official cash rate determines how much interest is paid to the Reserve Bank by financial institutions to use the RBA's money. When your financial institution lends this money to you for your home loan, for example, they do so at the interest rate they borrowed it at plus their margin. Lenders can determine their own home loan interest rates, raising them when the cash rate rises and dropping interest rates when the cash rate is lowered.

Case study

In 2002, Jack and Bonnie took out a variable rate home loan over 25 years. The rate their financial institution offered them was an attractive 6.32%, so for their $100,000 loan, Jack and Bonnie were repaying $664.00 a month.

By the end of 2003, interest rates had risen by half a per cent to 6.82% - still affordable for Jack and Bonnie, although repayments had now increased to $695.34 a month.

Over the following three and a half years, Jack and Bonnie continued to pay off their loan. Interest rates continued to rise slowly until, by August 2006, after yet another 0.25% rate rise, Jack and Bonnie were now paying $759.93 a month. Interest rates for their loan were now at 7.82%.

Jack and Bonnie's home loan interest rate had risen by 1.5% over the intervening four years. On their original loan of $100,000, this equated to an increase in repayments of $95.93.

If Jack and Bonnie hadn’t factored in the possibility of interest rate rises when they established their loan, they could have been in financial trouble four years later.

Don't fall into that trap of taking out a home loan that you can only just afford to pay off ; always consider the possibility that rates can rise.

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The rate debate: fixed vs. variable rate home loans

Home loans generally have either a fixed or variable interest rate, or a split rate - a mixture of both. A fixed rate home loan is taken out for a set period with a set interest rate; when this period ends you can fix the rate again, or switch to a variable interest rate which fluctuates with the market.

Variable and fixed rate loans are more or less appropriate in different financial environments, and for different types of lender.

Fixed rate home loans

Fixed rate home loans have traditionally been associated with rigid conditions, but with flexible new products available, and interest rates relatively low, fixed rate loans are currently quite popular in Australia (though not as popular as standard variable rate loans). The majority of fixed-rate home loans allow extra repayments and include redraw facilities.

A fixed rate home loan can be good if you want to carefully budget your repayment - knowing exactly how much you need to repay means you can plan accordingly and gives you a degree of certainty and security.

However, some fixed rate loans still charge you for making early repayments, which means that if your financial situation becomes more positive you will often have to either pay a fee, or keep the loan for the original term and pay the full interest amount.

If choosing a fixed rate loan, you also need to consider fairly carefully the term of the loan – usually between one and five years, but sometimes up to ten. The most popular fixed-rate loan term is three years - which seems to allow borrowers a sense of security with a certain degree of flexibility, but the choice of loan term needs to suit your specific situation.

Variable rate home loans

Variable rate home loans usually provide options and flexibility, but they can also be risky in a rising interest rate market if you’ve overcapitalised on your loan. The important thing to do when taking out a variable rate loan is to plan and budget for hikes in interest rates, and make sure that you’re able to meet your repayment obligations should rates rise.

Variable rate loans can include a range of extra features, and some loan products have low introductory, or “honeymoon” rates for an initial period before reverting to the standard rate. (More about home loan types.)

What do the experts say?

A number of experts suggest that fixed loans are a better option if there is an expectation of interest rate rises in the medium to long term. However, they also warn that the benefit gained may not be enough to counter the fees you could pay to switch from a variable to a fixed rate loan.

As with any home loan advice, the key is to examine your own financial situation, and only consider a change if the fees to make the change are outweighed by savings benefits.

Some experts point out that fixed rates rarely fall below the standard variable rate for a long period, and when they do it is usually a good idea to fix at least a part of your loan. Remember that you don’t have to fix all of your home loan, but you can split the loan between fixed and variable rates with a split rate loan.

Split rate loans: the best of both worlds?

A split rate loan allows you to split your loan amount between fixed interest and variable interest rates. This means that regardless of the economic situation your loan will be partially suited to it. However, it will also mean that you will be unlikely to receive the full benefits of a choice one way or the other.

Such a choice may suit your particular situation if you need some security, but also want the chance to pay off some of your loan ahead of time.

Choosing the loan that’s right for you

In the end your choice of a loan should be determined by your situation and your own financial priorities. It is difficult even for experts to make predictions about which direction interest rates will go in the long term – your choice needs to be made with your own financial goals in mind, and take account of your income stream and need for security or flexibility.

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Refinancing your home loan

With the selection of home loans currently available, many people are choosing to refinance their existing loan to take advantage of additional benefits and incentives offered by other lenders.

How does it work?

A new loan is established with either your existing lender or a new lender, with funds from the new loan being used to pay out your existing loan. It is the responsibility of your new lender to ensure your existing debt is settled in full.

Why refinance?

Refinancing is an increasingly popular method of accessing the existing equity in your home. Equity is the difference between how much you still owe on your home loan and how much your home is worth.

There are many reasons why people refinance their home loans including:

• the option to roll all your debts into one.
• to take advantage of a cheaper interest rate or lower fees.
• to take advantage of other features offered by other products.
• to switch from a fixed to variable rate loan, or vice-versa.
• to access the equity in your home to use for renovations, holidays, other investments etc.

When to refinance

Refinancing can be useful and financially rewarding but it can also carry risks. It takes time and costs money, so before you decide to change to another lender, ask yourself if it is really the right thing for you.

• Are you happy with your existing lender? Have they been professional and helpful in all the dealings you've had with them?
• Are you happy with your existing loan? Is the interest rate comparable to other lenders? Could you use some extra features offered with other products?
• Has your financial situation changed? Maybe you've started a new job or become unemployed.

Potential costs and implications

Refinancing an existing loan comes with many fees and charges. These include:

• application, establishment and handling fees when applying for your new loan. These can be substantial.
• early settlement fees on your existing loan. These vary depending on your lender but many fixed rate loans have significant penalties for early repayment.
• valuation fees; still required by some lenders.
• mortgage insurance. Required by many lenders if the loan is more than 80% of the property value.
• Discharge fees on your existing mortgage and registration fees on your new one.
• stamp duty.

Many people also get caught out with the hidden cost of additional interest payments. If you only have ten years left to pay on your existing home loan and you refinance, taking out a twenty year loan instead, don't forget to consider the additional interest that will be charged over the extra ten year period your new loan runs for. These additional amounts can soon add up.

Case studies

Phil and Brenda have an existing home loan. Their property is currently worth around $425,000 and, after ten years of paying their mortgage payments each month, Phil and Brenda now owe just $175,000 on their loan. This leaves the couple with equity of $250,000 in their home.

By refinancing their loan with another lender, Phil and Brenda can not only find a more suitable mortgage with a lower interest rate, they also choose to untie an extra $50,000 worth of equity, money they can use to invest elsewhere.

However, if Phil and Brenda have no immediate use for the extra $50,000, they can place the funds into the offset account (sometimes referred to as special repayments) supplied with the loan, meaning they don't have to pay any interest on the additional amount borrowed. Their basic financial situation has not changed. They still have a home loan of $175,000 to pay off, however they now have a reduced interest rate and $50,000 worth of accessible money they didn't have before.

Accessing equity isn't the only benefit of refinancing. Freda decided to refinance her home loan to consolidate all her debts into one, with a substantially reduced interest rate. By consolidating her personal loan (9.75%), credit cards (15.25% and 17.75%) and existing home loan (7.25%) into a new product with an interest rate of just 7.05%, Freda can make substantial savings over the life of the loan.

If you've decided that refinancing is the answer for you, make sure you research thoroughly all the options available to you. Decide on the type of new loan you require and be clear on the features you need.

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