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A line-of-credit mortgage is a mortgage program in which a homeowner can borrow against the equity of his or her home. Unlike taking out an additional mortgage, which is usually paid in a lump sum, a line-of-credit mortgage works more like a credit card where the borrower can repeatedly draw from the funds over time up to the limit of the equity owned. Though a line-of-credit mortgage can be a good way to finance large purchases such as home improvements or college tuition, it can carry a variety of risks. Some financial and real estate experts cite line-of-credit mortgages as one of the primary factors in the real estate crisis of 2008.
Every time a person makes a house payment, he or she gains a little bit more equity in the house. Over time, this equity can prove to be a significant financial asset, even though it is not easily liquidated into usable funds. A line-of-credit mortgage is one way to liquefy assets in order to pay for other purchases. By using the amount of equity as collateral, a homeowner can receive a line-of-credit from a lender, often with a fairly good initial interest rate.
A line-of-credit mortgage typically has two phases: an initial draw phase in which credit can be taken up to the amount of collateral equity, and a repayment phase where the money is paid back to the creditor. The draw phase may last more than 20 years in some cases, though some loan experts advise switching into repayment as soon as possible to lower interest costs. Throughout the draw phase, the borrower may be responsible for minimum payments, usually enough to cover the interest on the debt. After the draw phase has ended, the buyer usually has the option of repaying in a lump sum or setting up a payment schedule with the lender. The amount due will include the borrowed principle and the interest.
There are several issues that make a line-of-credit mortgage risky for some borrowers. First, almost all mortgages of these kind feature variable interest rates. Since the rate fluctuates with the market, this may mean that the original, reasonable interest rate can quickly skyrocket to unpayable rates. Since the term of a line-of-credit mortgage can span for decades, there is no reliable way of predicting how the interest rate will behave for the length of the credit term, and thus no way to tell if the deal will remain manageable.
Interest rates on line-of-credit mortgages also tend to be somewhat higher to begin with, because they represent a significant amount of risk for the lender. If a homeowner declares bankruptcy, the primary mortgage holder usually has first claim on defaulted property. line-of-credit mortgages, by contrast, are considered second-tier liens, and may end up with huge losses if any assets are already assigned to lenders with a higher-rated claim.