Line of credit 101
Whether you're facing a large, unexpected expense, or you're just struggling to get by until the next paycheque, it can be difficult to navigate all of your financial options when you're in a pinch.
Though most Canadians are familiar with how their credit card operates, a line of credit can still feel a bit mysterious. But this borrowing option offered by financial institutions simply gives you access to funds up to a set limit.
A line of credit can be a useful financial support during crucial times. And it may suit your needs better than a traditional loan, credit card or asking friends and family.
Remove all that mystery and learn all about how lines of credit work, how to use them and whether they're right for you.
What are lines of credit and how do they work?
A line of credit isn't so different from a credit card. A bank, credit union or other financial institution may allow you to borrow money up to a predetermined limit — typically at a lower interest rate than traditional loans or credit cards.
If you're approved for a line of credit, you're given access to these funds without a set timeframe for when you need to pay the balance back in full. Minimum payments are required as set out in the loan agreement, but as long as you meet those requirements, you can carry the balance indefinitely, at your applicable interest rate.
You can borrow from your line of credit at any time — or use and reuse those funds — up to your available credit without having to reapply. You can also use the line of credit however you choose.
Line of credit interest is only on what you've actually borrowed — not on the entire limit. For example, your bank may offer you a line of credit with a $10,000 limit, but if you've only borrowed $100, you'll pay interest only on the $100 until it's repaid.
Your financial institution will determine your credit limit and rate of interest, but you'll only need to apply for the line of credit once. Once approved, that money is available to borrow whenever you need it — often through online banking, cheque or even with an access card. Just be careful how you access the money, because using a line of credit for everyday spending means you're paying interest and taking on debt to pay for purchases that would make more sense using another type of product such as your chequing account or if you can pay the balance in full, a credit card or installment plan on that card.
How to use a line of credit
The great advantage of using a line of credit is its flexibility — and that extends to how and where you can use it.
Most people decide to take out a line of credit for one of two reasons. They want easy and quick access to cash for peace of mind, or to use for a project that may have variable costs. Let's take a closer look:
A rainy day fund: The common advice is to build an emergency fund with three to six months' worth of expenses. Easier said than done, right? If you don't have a robust savings account, a line of credit can offer quick access to money when you need it. And with lower interest rates, it's a better option than your credit card.
Ongoing projects: Doing some home renovations or repairs? The flexibility of a line of credit means you're prepared if the price starts to climb.
Consolidate higher-interest debt: Carrying debt on your credit cards or other high-interest loans can be costly. Consolidating your debt with a line of credit could help you pay less in interest.
Types of lines of credit: Secured and unsecured line of credit
Along with the extra flexibility of a line of credit come a few options to choose from.
Secured line of credit: Want to borrow a large sum of money with the lowest interest rates? A secured line of credit could be the solution. This involves using an asset — such as a property or Guaranteed Investment Certificate — as security. The lender can take possession of this security if you can't pay back your line of credit.
Unsecured line of credit: If you don't have that security available — or you don't want to risk losing your property if you can't repay what you've borrowed — an unsecured line of credit is another option. Because this poses more risk to lenders, you'll need to pay a higher interest rate than for a secured line of credit.
But even among these two varieties, there are several other types of lines of credit.
Personal line of credit
A personal line of credit is a basic, unsecured line of credit. Though the interest rates are often higher than secured lines of credit, they're still lower than those of credit cards and other personal loans.
If you qualify for a high enough credit limit, a personal line of credit can be most attractive to pay for large projects like home renovations or for transferring balances from higher-interest debt.
Student line of credit
Similar to a personal line of credit, a student line of credit is unsecured. But this type of loan is only available to part-time or full-time students that are enrolled at a recognized Canadian post-secondary institution.
Need a hand paying for tuition and other expenses related to your education? A student line of credit can help. You can also use it for everyday expenses while your head is in the books.
A student line of credit is a bit different from government student loans. The interest rates are typically lower on student lines of credit, but you'll need to start paying interest as soon as you borrow rather than once you finish your program or leave school.
You may also need somebody — like a parent — to co-sign your line of credit application. That person would be on the hook for your debt if you can't pay it back.
Home equity line of credit
A home equity line of credit (HELOC) is a loan that uses your home as security. Since it's secured against your home, you can get low interest rates.
To qualify for a HELOC, borrowers typically must own a home with at least 20% equity in their home, along with other qualifications set by the lender.
In addition to lower interest rates, credit limits on HELOCs can be much higher than other lines of credit. The limit is normally linked to the home's purchase or market value and the amount of equity the homeowner has in the home. The credit limit for home equity line of credit with a federal financial institution is currently 65% of the home's lending value.
Like other lines of credit, a HELOC comes with a variable interest rate based on the lender's prime rate. That means it can go up and down as interest rates change.
You can use HELOCs for all of the same reasons you might use other lines of credit. But many homeowners use this money for home renovation or repairs, seeing it as an investment into their home's value.
How does a personal line of credit affect my credit score?
Like mortgages and other types of loan applications, your credit rating gives the lender some idea about how risky it is to lend you money. If you have a higher credit score, your lender may offer you a lower interest rate and potentially a higher credit limit.
But taking out a line of credit can also impact your credit score.
Credit scoring models tend to favour those with a diversified credit mix — and that includes lines of credit. If you don't have a history of borrowing, a line of credit can help build your credit history. Similar to paying off a credit card on time, you'll need to ensure that you're paying the interest on the money borrowed in time to get that boost.
But making late payments, even just occasionally, can negatively affect your credit score. Not making at least your minimum payment can also have a negative impact on your credit score.
Pros of lines of credit
Depending on your situation, taking out a line of credit could be a shrewd move. Let's take a look at the advantages.
- A line of credit will typically come with lower interest rates compared to credit cards or traditional loans. A secured line of credit could come with even lower rates.
- A one-time application process that gives you access to funds when you need them without reapplying.
- You only need to pay interest on the amount you actually borrow — not the entire line of credit. You also may not be charged annual fees, depending on the lender.
- Your bank may let you transfer any overdraft on your regular account to your line of credit, potentially saving you fees.
- You can use your line of credit for anything, spanning from your rainy day fund all the way to financing a car or home.
Cons of lines of credit
Does this all sound too good to be true? Not so fast — lines of credit also come with some disadvantages.
- Easy access to money can be tempting. Ensure your spending doesn't get out of control by borrowing an amount of money that's higher than your needs.
- Lines of credit come with variable interest rates, meaning your monthly bill could balloon if interest rates rise.
- It could take a long time to pay off the balance (or you might never get there) if you're making minimum payments or the payments are interest only. You need to be disciplined to pay it off.
- A secured line of credit — for example, using your home as security— could be risky. If you can't pay off the credit, the lender can take your house.
- Like other debts, missing your payments could hurt your credit score.
Line of credit vs. loan
On its surface, a line of credit might seem to have a lot in common with a traditional loan. You apply for one of these financial products from your financial institutions and, in some cases, the funds could be used for the same purpose.
But there's a lot that separates a line of credit from a personal loan:
- A loan comes in a lump sum with a strict repayment plan, rather than a reusable line you can access at any time. Once you've paid off a loan, you can't borrow any of the funds back unless you get approved for a new loan.
- Interest is calculated on the full loan amount and you can choose from weekly, bi-weekly, semi-monthly and monthly payments.
- Loan interest rates can be either fixed or variable, but are typically higher than line of credit interest rates.
Is a line of credit right for me?
Now that you're equipped with all the details, you can decide if a line of credit is the right borrowing option for you given your financial needs, circumstances, and goals. To help you decide, consider asking yourself the following questions:
Do I need flexible access to money?
Do you only need funds for a single expense? If you don't need the most flexible option, you may prefer the structure of a traditional loan. But if you do opt for a line of credit and don't need to keep it open, you can typically close it early without penalty.
Do I have more than one big purchase coming up?
Whether you're going back to school or investing in some home renos, a line of credit could be ideal if you aren't completely certain of your future expenses.
Can I make my interest payments?
Even though you'll only need to pay interest on the amount you borrow, ensure you can actually make those payments. With variable rates, you also need to be prepared for the possibility that rates could go up — and your bills along with them. This is doubly important with a home equity line of credit, where you could even lose your home if you can't pay off your credit.
When it comes to important personal finance decisions, remember to do your research.
