A closed-end line of credit combines the features of a closed-end loan and a line of credit. Closed-end lines of credit are often used for home building. Here is what you need to know about how a closed-end line of credit works.
- A line of credit is a type of loan that borrowers can take money from over time, rather than all at once.
- There are two basic kinds of lines of credit: closed-end and open-end.
- A closed-end line of credit must be repaid at a predetermined point, while an open-end line of credit has no fixed end date.
- Closed-end lines of credit are often used in home building, after which the home's owner will refinance with a regular mortgage.
What Is a Closed-End Line of Credit?
A line of credit is a type of loan that allows borrowers to take out money as needed, up to a certain predetermined limit. Lines of credit can be either open-ended or closed-ended.
Open-end lines of credit have no fixed end point when they must be repaid. (That is why they are called open-end.) Credit cards are a familiar example. With a typical revolving credit card, the lender gives you a credit limit you can't exceed, which is based on your credit score and other factors. As you charge purchases to your card, the amount of credit you have available to you on the card will decline. When you pay your monthly credit card bill, your available credit will rise. This can continue for as long as you hold that card.
Reverse mortgages for homeowners age 62 and over can also be structured as open-end lines of credit. The lender sets a credit limit based on the value of the home and the borrower's age, which the borrower can then draw on as needed. There is no fixed end point, but the loan must generally be repaid after the borrower dies or moves out of the home. The borrower may also have the option to make repayments while they're still in the home, which will replenish their credit line, much like a revolving credit card.
Unlike open-end lines of credit, closed-end lines of credit do have a fixed end point. You can borrow up to the credit limit but must repay your balance in full when the loan ends. Typically the credit line will have a draw period, during which you can make a series of withdrawals, followed by a repayment period when you must begin to pay it off. Some closed-end lines of credit require interest-only payments during the draw period. If you wish to, you can also pay off a portion of your balance before the repayment period, but, unlike an open-end credit line, that won't increase your available credit.
Closed-end lines of credit can have different terms, or lengths, and tend to be relatively short. A typical construction loan, for example, might have to be paid off after six months or a year.
While you may make regular interest payments on a closed-end line of credit, they won't reduce the amount of principal you owe when the loan comes due.
How a Closed-End Line of Credit Works
Suppose you're about to begin construction on a new house for your family. In order to finance it, you apply for a closed-end line of credit lasting for six months. The lender might offer you a credit line equal to 80% of your expected building costs.
Because you won't need the money all at once but will be paying the contractor at various points in the project, you can draw on the credit line in a series of predetermined stages (such as the pouring of the foundation) or, in some cases, regular intervals. You don't have to pay off the loan until the home is completed, but you will probably be required to make interest payments each month.
When the house is finished, you will have to pay off the line of credit. One way to do that is by taking out a regular mortgage and using the new home as collateral. Some lenders offer construction-to-permanent loans, which combine both loans into one application process and one closing. Otherwise, you'll need to apply for the two loans separately and at different points. That could be a problem if, for example, your financial situation changes for the worse by the time you're ready to apply for the mortgage, making you less likely to qualify.
What Is a Closed-End Loan?
A closed-end loan is one in which the borrower receives a sum of money that they must repay by a certain date, often in monthly installments. Home mortgages and car loans are two common examples. Mortgages often have to be repaid in 15, 20, or 30 years, car loans in 24, 36, or 72 months—although there are many different options. Typically, the longer the loan, the lower the monthly payment, although the borrower may pay more in total interest over time.
How Does a Closed-End Line of Credit Differ From a Closed-End Loan?
In the typical closed-end loan, the borrower receives a sum of money upfront. By contrast, in a closed-end line of credit, the borrower can take out money in a series of withdrawals over a period of time, up to the credit line's limit. Closed-end lines of credit may also require interest payments from the borrower, but not principal repayments until the full loan comes due.
Is the Interest on a Closed-End Line of Credit Tax-Deductible?
That depends on what you use the money for. For example, you may qualify for a home mortgage interest deduction if you're building a home. According to the IRS, "You can treat a home under construction as a qualified home for a period of up to 24 months, but only if it becomes your qualified home at the time it is ready for occupancy. The 24-month period can start any time on or after the day construction begins."
The Bottom Line
A closed-end line of credit can be useful for certain purposes, such as when you need to borrow money for an expensive project, like building a home, but don't require the money all at once. Unlike open-end lines of credit, closed-end lines of credit have to be paid off in full by a certain point, which is important to consider before you enter into one.