A Line of Credit is a tool for those who have a good credit score/rating. It is as simple as it sounds. Because you have a history that shows that you understand and have managed your budget and your balance sheet properly, you have the financial savvy to handle a flexible loan. You get a loan that you can choose to use or not use at any given time. You can borrow against it any time up to your given limit. You can pay part of it off or all of it off when your financial situation allows. If you do have an outstanding balance you have to pay a minimum payment every month. It may be as simple as just paying the interest accumulated each month.
When you are busy building your life, you have times when you are flush with cash and times when you need some financing. Your income patterns may be erratic where you have projects that pay every 2 or 3 months so the cash can get low while waiting for a payday from a big project. Having a line of credit saves you time and saves the bank time. The bank trusts that you will get paid so why would they waste their time and your time negotiating a loan every time you need some bridge financing. You save time because you are busy on your project instead of applying for loans when you need them. Not only do you save time but because the lender knows you are low risk for missing payments they will not incur costs to pursue payment of the debt. They pass that savings on to you in the form of a low interest rate on the line of credit.
Unsecured Lines of Credit
If you have a strong balance sheet (a medium to high net worth) and a good credit history banks and other institutional lenders will give you a line of credit with a limit as high as in the tens of thousands and require no lien against any asset that you may own. In recent history lenders lost their minds and were giving out lines of credit to those who did not have the qualifications. I believe we are back to these boundaries once again. The only way lenders should give this tool out is when the client has shown that they have the character to manage it responsibly.
That is because these are viewed as revolving lines of credit. That means that you should use them for short term cash flow solutions. When the cash flow problem is solved and it should be in the short term, you pay the line of credit balance back to $0. It should not be used to finance consumer spending. If you do the line of credit becomes a permanent spending item on your budget and is a liability with no offsetting asset on your balance sheet. That means it reduces positive cash flow and reduces your net worth. If you use it to buy an asset, the asset offsets the liability and the impact on your balance sheet is 0. If you buy an appreciating asset and you pay off the line of credit, you have scored an A+ in line of credit management.
Secured Lines of Credit
When you have significantly paid down your mortgage you may choose to give yourself some budgetary freedom by negotiating a secure line of credit. The lender will hold a lien against your home and you can negotiate a line of credit with a limit in the hundreds of thousands of dollars. You may have a portion set aside to cover paying off the first mortgage and then the rest is yours to manage. Those who have achieved this level of financial competence will have project in line for that money. It may be a renovation or the purchase of another asset like a cottage. It may be for an investment that has a much higher return than the interest rate charged by the lender.
The effect on ones budget is that you get out from under your mortgage payment. It was set as 30% of your income at some point and you may wish to reduce that monthly cash draw. If you have an opportunity like the one just identified, you actually increase your income and can pay down the mortgage part of this debt faster than if you had just retained the mortgage. If you want a month off from paying the debt down and want to use the cash flow for a vacation you can. On your balance sheet you will have the equity in your home to offset the liability of this line of credit. If you are smart and disciplined enough to get to this point you will not use the credit for extravagant spending. If you use it for a renovation, you should increase the value of your home to offset the debt incurred. In the case you borrow the money to invest you can use the cash flow from the investment to pay for the interest. At tax time you can write off the interest as an expense, pay the taxes and there should be a substantial amount left over as profit. If you buy an appreciating asset, the appreciation goes directly to increasing your net worth.
Conclusion
This is a powerful borrowing tool for the regular Joe or Jane Doe. Use it wisely to continue to improve your personal financial position and power. Do not use these tools for extravagant spending such as luxury cars. Such assets depreciate quickly. You are left with the debt to pay and an asset that reduces your net worth year after year. Use these tools to bridge the gap between lows and spikes of income. And use them to buy positive cash flow investments or appreciating assets. That is what they are for.
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