All you need to know about a line of credit

The basics

A line of credit (LOC) is an open-ended loan that lets you borrow money at any time, up to a predetermined limit. Once you have one, you can borrow, repay and borrow again up to your credit limit without having to reapply. And you are free to use the money for any purpose you choose.

Unlike a personal loan, there is no set schedule to repay the money you borrow from a line of credit. However, you must make monthly interest payments on any amount you borrow, as interest begins to accrue from the very first day you borrow the money until the day you pay it back.

How does a line of credit work?

It might help to think of a line of credit as a bucket of Loonies you draw from. The bucket has a set capacity, say 1,000 Loonies. You can borrow however many you want — $1, $10, $100, or the entire bucket of $1,000 — whenever you want, and you will pay interest only on the number of coins you have out at any given time. You can refill the bucket as often or as infrequently as you want. But once that bucket’s empty, you won’t be able to borrow any more Loonies until you start refilling it.

You can set up a line of credit with a bank, credit union, or other financial institution to determine your credit limit and variable interest rate. Once approved, you can access your available credit whenever you like by ATM, cheque, or online banking, so long as you keep your account in good standing by making your interest payments on time.

How to use a line of credit

Here are some common reasons why you might opt to take out an LOC:

• To use instead of an emergency fund
• To pay for home renovations or repairs, which involve high up-front expenses but can be a good investment
• To buy a vehicle or any other big-ticket item
• To consolidate higher-interest debt
• To invest
• For education expenses
• To finance a portion of a home purchase

Types of LOCs: secured and unsecured lines of credit

LOCs come in two basic varieties: secured and unsecured.

With a secured line of credit, borrowers use a high-value asset they own, usually a home, as collateral against the loan. Lenders can feel confident that even if a borrower defaults on their payments, they can still recover the loan’s value by taking possession of that collateral asset. Because of this reduced risk to lenders, they will usually offer better interest rates on secured lines of credit than on unsecured ones.

An unsecured line of credit has no asset of value underwriting the loan, making it harder for borrowers to qualify. The most common unsecured lines of credit are personal and student lines of credit, while the most common secured LOCs are home equity lines of credit (HELOCs).

Personal line of credit

This is the most basic line of credit available to Canadians. Because it is unsecured, there is no risk that borrowers will lose their homes or other collateral assets if they default on payments. Instead, it’s the lender that holds most of the risk, so interest rates aren’t as favourable as those on a secured line of credit.

Having said that, the rates offered on personal lines of credit are still usually lower than for credit cards, personal loans, or other short-term loans. As such, borrowers commonly use personal lines of credit for consolidating higher-interest rate loans or for unexpected expenses.

Home equity line of credit (HELOC)

As a secured line of credit, a HELOC offers relatively low interest rates, usually around 0.5% to 2% above the lender’s prime rate. To qualify, borrowers typically must own a home with at least 20% equity — meaning that any balance on the mortgage is less than 80% of the home’s value.

The credit limits on HELOCs are often higher than other types of loans or lines of credit, as they can go up to 65% of the home’s purchase price or market value. With the average home price in Canada hovering close to $500,000, that means a typical Canadian homeowner with 20% equity could have access to a HELOC with a $320,000 credit limit. Because of these larger limits and low interest rates, borrowers commonly use HELOCs to finance major expenses, such as home renovations. A HELOC can also be used as a substitute for a mortgage (if your down payment or equity is at least 35% of the home’s purchase price/market value) or combined with a mortgage, also called a re-advanceable mortgage.

Line of credit vs. loan

There are a few key differences between a loan and a line of credit. A personal loan is a set amount of money you borrow to help pay for something specific, such as a car or a new dishwasher. Interest is calculated on the full loan amount and the debt is paid off in weekly or monthly installments. Once you’ve paid off the loan, you’re done. You can’t borrow any of the funds back again unless you apply for a new loan.

On the other hand, a line of credit is a form of revolving credit, which means you can borrow, spend, and repay money on an almost endless cycle. Interest is calculated only on the money you borrow from your line of credit, and there is no set schedule to repay those funds.

In terms of cost, there are pros and cons to both forms of credit. The rate of interest you would pay on a line of credit is usually lower than what you would pay on a loan. But you could end up paying more interest fees with a line of credit if you don’t repay the money you’ve borrowed on a timely basis. Here’s a direct comparison of not only LOCs and personal loans, but also HELOCs and credit cards:

Is a line of credit right for me?

To help you decide if a line of credit makes sense for you, here is a list of the advantages and disadvantages of this form of borrowing.

Pros of an LOC

• It usually has lower interest rates than personal loans or credit cards.
• You pay interest only on the amount you borrow, not the entire line of credit.
• There’s flexibility to pay back the money on your own schedule.
• No penalties for paying off your line of credit “early” or “late”.
• A one-time application process.
• It may save you money on bank fees if your bank lets you transfer any overdraft on your regular account to your line of credit.

Cons of an LOC

• Interest rates are variable; if they rise, you might have difficulty making payments.
• You must be disciplined to pay back the money you borrow since there is no set repayment timetable.
• You might be more tempted to overspend when you have credit readily available.
• Your bank or another lender can lower your credit limit or demand that you repay the loan at any time (with notice).
• If you miss payments, your credit score will suffer, making it more expensive for you to borrow in the future.
• With a secured line of credit, you could even lose your home or another secured asset if you miss payments.

How to get a line of credit

If you’d like to open a line of credit, you can make an application online, over the phone or in person at a bank or other financial institution.

The lender will determine how much you can borrow (your credit limit) and what rate of interest you pay based on several factors:

• Household income – most require at least $35K to $50K to qualify; except in the case of a student line of credit where a parent co-signs
• Ability to repay – includes your income stability and how much other debt you currently carry
• Credit history and credit score – the higher your score, the better the interest rate you’ll be offered
• Home value – for a home equity line of credit only
• Program of study/school – for a student line of credit only

Remember, you can shop around or negotiate with a lender if you’re not happy with the credit limit or interest rate initially offered to you. Also, don’t feel pressured to take the full credit limit; just like with a credit card, you can ask for the limit to be lowered to an amount you are confident you can pay back.

Finally, be sure to ask about any administrative fees (or legal, title search, or home appraisal fees for HELOCs), the lender charges, and how much notice they will give you before making interest rate changes.

Best line of credit rates in Canada

Canadian financial institutions typically don’t offer specific, universal interest rates for their LOCs. Instead, they usually determine LOC interest rates on a case-by-case basis depending on an applicant’s income, existing debt, and credit score. The interest rate the applicant receives is a combination of the financial institution’s prime rate and an ‘adjustment factor’ based on their financial profile. This variable interest rate will then go up and down as the prime rate gradually changes.

Most Canadian banks have the same prime rate, but there might be other small differences in their LOC offers, and some even have promotions from time to time. If you have a strong credit score, you can simply apply for an LOC with your usual bank, or you might be able to get a better rate at a competing bank.

If you’re a subprime borrower — i.e., you have a below-average credit score — you’ll probably be turned down for an LOC with a traditional bank. But you can still get a line of credit via alternative online lenders like Mogo or LendDirect. Keep in mind that a low credit score will correspond to LOC offers with high interest rates, which can really add up if you make only the minimum payment on your LOC. Before signing up for an LOC, you should make sure that its lender won’t charge you a fee for early repayment; this caveat is even more critical for subprime borrowers, who will want to repay whatever money they withdraw from their LOC as quickly as possible.

FAQs

What is a line of credit and how does it work?

A line of credit (or LOC) is a revolving credit product issued by financial institutions. Accountholders can utilize funds from the LOC up to its maximum credit limit, and the LOC’s available credit is refreshed as the accountholder repays what they’ve used.

What is the difference between a loan and a line of credit?

Funds from a loan are typically provided to a borrower in a lump sum. If the borrower then wishes to borrow money again, they must apply for a new loan. Those that have a line of credit can draw funds, repay, and draw funds again repeatedly up to the line of credit’s maximum credit limit.

Is a line of credit a credit card?

Both a line of credit and a credit card are forms of revolving credit, but they are different products. Unlike most credit cards, used credit from an LOC is subject to a variable interest rate, and there is no grace period before interest begins to accumulate on funds drawn. Furthermore, LOCs typically do not generate cash back or rewards points like many credit cards do.

How long does a line of credit last?

The period in which an accountholder can use funds from a line of credit, its draw period, will typically last around 10 years or so. This is followed by a phase in which the accountholder must repay any outstanding principal drawn, as well as interest on that principal.

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