Line of credit vs. loan
While most of us have heard the term line of credit (one of Canada’s most popular forms of consumer debt), not everyone has a clear understanding of how they work. Generally speaking, an LOC is one of the cheapest and most flexible ways to borrow money.
They are open ended (meaning there’s no deadline by which you have to pay them back) and you pay interest only on the money you actually take out. For example, if you have an LOC approved up to a predetermined limit of $5,000 and withdraw $500 then you only pay interest on the $500. Once you repay the $500, interest stops accruing and you once again have access to the whole $5,000.
You can use the money from an LOC for any purpose you like. As with any loan, you do, however, have to make timely monthly minimum payments on any amount you do take out according to the interest rate (usually a rate of X% plus prime, which is set by the Bank of Canada) and the agreement you have with your bank or private lender. Because of generally low interest rates and the fact that you only pay interest on what you actually withdraw, LOCs are definitely a cheaper way to borrow than keeping a balance on your credit card, and they often feature rates that are slightly lower than interest rates for personal loans.
There are various kinds of LOCs, including secured, unsecured, a home equity line of credit (discussed below), and a student line of credit. A secured line of credit is when you use an asset, such as investments or a house, as collateral against defaulting on your LOC. With an unsecured LOC, you don’t use an asset as collateral and therefore the interest rates are slightly higher than with a secured LOC.
Personal loans are similar to LOCs in that you are borrowing money and paying interest on it. Both types of borrowing also can have a significantly positive or negative effect on your credit score, depending on how responsible you are about making your payments.
However, loans are different than lines of credit in several significant ways. With a loan you borrow a set amount of money from a bank, credit union, or other financial services institution for a specific purchase (like a vacation, car, investment or even to consolidate other higher-interest debts). You also agree to pay the loan off within a specific period of time. A personal loan, like an LOC, can be secured or unsecured, but unlike an LOC, you pay interest over the period of your loan on the whole amount of credit you borrowed. The interest rates and loan period will depend on whether the loan is secured or unsecured, as well as each institution’s personal loan rates.
Line of credit vs. credit card
Lines of credit are similar to credit cards in that you can borrow off and on, up to a set amount as you see fit, and you only have to make interest payments on the amount you actually use. As with LOCs, you are also expected to make minimum monthly payments with credit cards.
Lines of credit, however, almost always have lower interest rates (often between 5% and 10% depending on what prime is) than credit cards—which often have annual percentage rates hovering around 19% and above. LOCs can therefore make a smarter, more manageable choice as a borrowing option. That said, there are some credit cards that do offer attractive low interest rates for those that want the instantaneous purchasing power of a card.
Many credit cards also offer reward points or cashback bonuses, as well as others perks like extended warranties and insurance packages. Those perks, however, frequently come at the cost of an annual fee.
Line of credit vs. mortgage
If you hope to be a home owner, you may likely be faced with the challenge of coming up with a huge amount of money quickly to purchase a property worth thousands of dollars. However, regular personal lines of credit are not really designed for big ticket purchases, like houses. Rather, they are intended for medium-sized expenses like a home renovation or a family vacation, which can be paid back within a relatively short period of time.
In contrast, mortgages are loans that are specifically intended for a major property purchase. They are usually available in 5-year terms that are amortized (paid out) over 25 years—though the amortization period can be longer or shorter. After each five-year term, the terms can be renewed and renegotiated with your lender. You can choose to go with a variable rate (a rate that fluctuates based on the Bank of Canada’s prime lending rate) or a fixed rate (a set and guaranteed rate for the length of the term).
Home equity line of credit vs. mortgage
A home equity line of credit is more comparable to a mortgage: It uses your house as collateral for your loan. However, because you usually have to have some ownership (equity) in a house before you get a HELOC, home equity lines of credit are considered more as a type of mortgage add-on.
The amount of a HELOC is usually less than a mortgage, and as with a personal line of credit, you take money out only when you need it and pay interest only on the money you withdraw. This flexibility is one of the most attractive features of a HELOC versus a mortgage. With a HELOC you must make monthly minimum payments, but you can pay off the interest and principle amount as you like. With a mortgage, however, you must make payments on both the lump sum you borrowed and the interest, and you run the risk of incurring pre-payment penalties if you make extra payments in an effort to reduce the principle amount you owe.
Deciding between a HELOC or a mortgage will likely come down to whether or not you already have a property you can use as collateral and how much money you need to borrow. Taking out equity in your home will also look different depending on whether you have a conventional or collateral mortgage, so that’s something you also need to take into account.
What’s the best choice for borrowing money?
There’s no one-size-fits-all approach for borrowing money. It really depends on your personal circumstances.
Overall, lines of credit are becoming much more popular in Canada because of their fair interest rates and flexibility. If you’re looking just to help finance a renovation or fund your new business and want access to credit that you only draw upon when needed, an LOC or a personal loan are likely the best options for you. However, if you are looking to finance the purchase of a home and will probably need a couple of decades to pay off the loan, a mortgage will offer you more access to a larger chunk of cash than an LOC would and is still the most common form of loan for a property purchase.
Ultimately, you should choose an option that realistically suits your lifestyle and financial circumstances. Do a little research, make a budget and compare lenders—that way, you’ll know what you’re getting into before you sign on the dotted line.