What is a revolving credit?
A revolving credit is a type of mortgage, where a small part of your home loan acts like an overdraft.
But, if you convert part of your mortgage into a revolving credit – it’s an overdraft that’s already maxed out, and you still have to pay back.
Here’s how it works.
Let’s say you have a $500K mortgage. Now, chip off a chunk of that mortgage – say $10K … that’s your revolving credit.
But, rather than have a 15% interest rate like some other loans and overdrafts, it’s on a home loan rate, which is 4% or 5% in today’s money.
However, you only pay interest on money outstanding, not the money you have paid back.
So, if you have a $10K revolving credit, but have managed to put $4K in that account, you only pay interest on the outstanding $6K.
What are the pros and cons of using revolving credit?
If you ask a mortgage broker, most will say everyone should use a revolving credit … but only if you use it properly.
Here’s why.
Pro – revolving credits are flexible
Revolving credits are flexible. In technical terms, they are liquid.
Any money you put in can be taken out, the same as any other bank account.
That’s why many borrowers will put all their salary and wages into their revolving credit, and then pay their expenses out of this account.
While they have money in there, the amount of interest they pay is temporarily reduced.
Some investors find this flexibility really pushes them to pay down that mortgage more rapidly, with the comfort of knowing that you can access that money in an emergency.
For instance, if you’ve managed to put $10,000 into your revolving credit but then your car breaks down – you can take that money back out to cover repairs.
If you were to do that with your standard P+I loan, not only are you limited to how much extra you can pay back (5% for most banks without incurring fees) you will have to apply to get that money back out if you need access.
So, how do you set up a revolving credit?
The best action plan is to go through a mortgage adviser, but you can go directly to your bank.
The first step is to figure out how much extra money you can realistically put towards paying off your mortgage within a year. That’s the amount you’ll set your revolving credit up for.
For instance, let’s say you can put an extra $300 away a week. This adds up to $15,600 in a year.
In this instance, you’d typically break off $15K from your mortgage (we’ve rounded for simplicity) and put it in the revolving credit.
This revolving credit now works like a transactional account. All your wages go into it, and all your bills go out. What’s left stays in there and gradually pays it off.
The available balance starts at zero. So, you save $300 one week and you’re at $300; in a month you’re at $1200 … and so on.
At the end of the year, when you reach your $15,000, you put this entire amount back into your main mortgage.
Here’s a graph that models how much more quickly you can end up paying your mortgage off by using revolving credits.
#2 – To fund your renovations
Let’s say your mum wants to renovate her existing property. In this instance, she could take out a $50,000 loan, withdraw all the money at once, and go for gold at Bunnings.
But the issue here is not all of her expenses are going to come up all at the same time. The nature of renovations, like many projects, is money must be spent as you go.
But, if you take out a full $50k loan as a mortgage top-up you have to start paying interest on the full $50k straight away.
So, even though she is spending the money slowly, she is still paying the interest on the full $50K.
This is why it could be a good idea for her to set up a $50,000 revolving credit secured against her home.
This way, she can take money as she needs it and she’ll only be paying interest on the money as she spends it.
But … isn’t this just a loan?
In case you’ve got this far and you’re thinking: “Isn’t this just a loan with a fancy name?” Well, no, there are key differences.
Firstly, revolving credits work really well when you know you have a certain amount of money to spend, but you don’t have to spend it all in one go.
This is because you pay interest on the money you actually spend, rather than interest on the entire amount.
For instance, let’s go back to our renovating mum. If she took out a loan for $50,000 she’d have to pay the interest on that loan – the full $50,000 – on a fixed rate, regardless of the fact that she’s going to spend it in increments.
But, with a revolving credit, you only pay interest on the money you actually spend.
Common mistakes when using revolving credit
Earlier in the article we listed a revolving credit’s liquidity as one of its pros. However, this flexibility can also work in the other direction.
This is because the voluntary money you’ve saved is not locked away behind the bank’s bars. Instead, it’s there for you to freely and all-too-easily take out and spend.
This is why some people, who want to pay down their mortgage quicker, would rather just up their minimum mortgage repayment. Once it’s paid out, there’s no easy way to access it.
This is similar to other more forced saving schemes like KiwiSaver. This is money that is squirrelled away every paycheck.
Yes, you can access it for certain purchases, but they have specific guidelines attached to them; e.g. hitting retirement, buying your first home, or if you are in financial hardship.
This is why some financial advisers call them “revolting” credits, because they don’t always work as well as they should on paper.
It all depends on your money personality, and how disciplined you are.
Who is a revolving credit the right fit for?
While there are some who would claim the revolving credit is the “greatest invention the mortgage industry has ever seen”... it’s not the right fit for everyone.
As we’ve said, the flexibility a revolving credit provides can also be its downfall.
You’ve got to be disciplined, otherwise you risk spending all this money you have so diligently saved.
So, if you’re not disciplined with your money, it’s not going to be the right fit for you.
Similarly, don’t get a revolving credit if you are only going to make minimum repayments. It makes no sense in this instance.
If you think you’re someone who would struggle not to spent your extra money, why not consider just upping the mortgage payments so you can’t touch them (easily) once they are gone.
But if you’re a disciplined spender, you’re determined to aggressively pay down your mortgage, and you find encouragement from having a goal to meet – then yes, this might be a good fit for you.
In this case, it might pay to have a conversation with your mortgage broker about setting up a revolving credit.
