A line of credit is a type of loan that can be super useful in the right circumstances. What makes lines of credit so useful and so flexible is the fact they work a little more like a credit card than a traditional loan.
With a line of credit, you have access to a set amount of money that you can spend and repay – and you only pay interest on the money you’ve spent, not on the full amount you have access to.
Understanding Lines Of Credit
What Is A Line Of Credit?
A line of credit is considered a revolving form of credit. That means the credit is automatically renewed as debt is paid off. You apply for lines of credit from financial institutions like banks or credit unions.
Unlike a traditional loan, where you borrow a lump sum from the bank that you start immediately paying fixed installments on, a line of credit provides a pre-approved credit limit. You have access to draw from it.
With a traditional loan, you’re paying interest on the borrowed amount from the get-go, but with a line of credit, you only pay interest on the portion of the credit you actually spend. As you repay that borrowed amount, your available credit replenishes, allowing you to reuse it over and over during the specified term.
Let’s look at an example where you borrow $10,000 from a bank and only spend $2,000. With a traditional loan, you’re still paying interest on the entire $10,000 even though $8,000 remains unspent in your account. With a line of credit, you only pay interest on the $2,000 you’ve spent.
Key Features Of A Line Of Credit
Revolving Credit: As mentioned, a significant feature of a line of credit is its revolving nature, offering ongoing access to funds without the need to reapply for a new loan. During the term of the line of credit, you can spend and repay the funds as many times as needed.
Variable Interest: Lines of credit typically come with variable interest rates, meaning the interest charged can fluctuate based on prevailing market rates. This can be both a positive and a negative, depending on the state of the market.
No Fixed Repayment Schedule: Unlike traditional loans, lines of credit offer flexibility in repayment. You only need to make minimum monthly payments based on the amount you’ve borrowed. You can repay the entire balance or just a portion of it at any time.
Secured and Unsecured Options: Some lines of credit require collateral, such as a home or vehicle. The asset secures the line of credit. Others are unsecured and rely only on your creditworthiness.
Benefits and Drawbacks Of Lines Of Credit
Benefits Of A Line Of Credit
Flexibility: Lines of credit provide the freedom to borrow what you need when you need it, from a predetermined amount, making them ideal for managing irregular or unpredictable expenses.
Lower Interest Rates: Compared to credit cards, lines of credit often come with lower interest rates, especially if you have a good credit score when you apply for one.
Access to Emergency Funds: Having an available line of credit can serve as a financial safety net during emergencies or unexpected situations.
Drawbacks Of A Line Of Credit
Temptation To Overspend: The flexibility of a line of credit can be a blessing, but it may tempt some people to borrow beyond their means. That flexibility needs to be managed so you don’t overspend, increase your debt and potentially create financial strain.
Variable Interest Rates: This isn’t always a drawback – but it certainly can be. Because lines of credit have variable interest rates, if they increase you’ll suffer higher borrowing costs.
Potential Collateral Requirements: Secured lines of credit sometimes require your most valuable assets to be included as collateral, meaning if you fail to pay back what you owe the bank could take possession of your house or car.
Risk Of Debt Accumulation: If not managed responsibly, a line of credit – just like any other type of loan – can lead to debt accumulation and put you in a hole it can be difficult to climb back out of.
Types Of Lines Of Credit
Personal Line Of Credit
A personal line of credit is designed for individuals. These can be used for whatever personal expenses you may have coming up, such as home renovations, travel, or paying for education. These can be either secured or unsecured.
Home Equity Line Of Credit (HELOC)
A HELOC is a secured line of credit that allows homeowners to borrow against the equity in their property. Your house acts as collateral with a HELOC. These are commonly used for home improvements or consolidating high-interest debts. HELOCs usually have lower interest rates and higher borrowing limits.
Student Line Of Credit
A student line of credit is designed to help you pay for post-secondary education and associated costs, like books and rent. These are only available to students at recognized Canadian post-secondary institutes. Other options to a student line of credit are scholarships and bursaries.
How Does A Line Of Credit Work?
When you’re approved for a line of credit, the lender sets a credit limit. This is the total you have access to and the maximum amount you can borrow.
The amount available to you at any given time is referred to as the “available credit.” So, if you have a $10,000 line of credit and you’ve spent $2,000, you’ll have $8,000 left in available credit.
Accessing Funds From A Line Of Credit
Cheques: Often you’ll receive a chequebook with a line of credit which you can use to pay people and bills directly from the credit line.
Online Transfers: Many financial institutions allow you to transfer money from your line of credit to your bank account through online banking.
Debit Card: Often a debit card will also be issued, linked to your line of credit, allowing you to make purchases or withdrawals as needed.
Interest and Repayment Of A Line Of Credit
When you borrow from a line of credit, you’re charged interest on the amount you’ve borrowed using the applicable interest rate. It’s essential to make timely payments to avoid accruing additional interest and to maintain a positive credit history.
Comparing Lines Of Credit To Other Types Of Borrowing
Differences Between A Line Of Credit And Credit Cards
While lines of credit and credit cards offer access to revolving credit, they differ fundamentally in some ways.
Repayment Terms: Credit cards typically require a minimum monthly payment, but you can carry a balance indefinitely. Lines of credit have set terms and require full repayment at the end of the term.
Rewards Programs: Credit cards offer rewards programs to incentivize spending and repaying. Many also come with insurance to cover purchases and travel. Lines of credit do not offer benefits like these.
Interest: Credit cards often have higher interest rates than lines of credit. This makes lines of credit more cost-effective for more significant expenses. Credit cards give you a one-month grace period before interest kicks in on your spending. Conversely, lines of credit begin charging interest as soon as you spend.
Differences Between A Line Of Credit And Personal Loans
While they both give you access to money you can borrow, lines of credit and personal loans operate quite differently.
Lump Sum vs. Revolving: Personal loans provide a lump sum upfront, while lines of credit offer ongoing access to funds with the ability to borrow and repay multiple times.
Interest Calculation: You calculate interest on the entire amount of a personal loan. However, lines of credit charge interest only on what you’ve spent.
Repayment Structure: Personal loans have fixed monthly installment repayments, while lines of credit offer more flexibility in repayment.
Qualifying For A Line of Credit
Credit Score And Credit History
Your credit score and credit history significantly influence your eligibility for a line of credit. Lenders use this information to assess your creditworthiness and determine the terms and conditions of a credit line. A higher (better) credit score and a positive credit history show you’re responsible with money and may increase your chances of approval.
Income And Employment Criteria
Lenders will also consider your income and employment to assess your ability to repay the line of credit. A steady income and stable job will help you get approved for a line of credit.
Level Of Debt
Lenders will also evaluate your debt-to-income ratio, which measures your total debt obligations compared to your income. A lower ratio demonstrates better financial health. If you already have significant outstanding debt and don’t have the capacity to easily repay it, lenders may be cautious about extending additional credit.
Finally, Tips for Managing A Line Of Credit Responsibly
To make the most of a line of credit while safeguarding your financial well-being, you need to employ responsible borrowing practices.
Set A Budget And Limit: Before accessing funds from your line of credit, carefully assess your financial needs and set a budget. Use a line of credit only for essential expenses or planned purchases.
Make Timely Repayments: Always make at least the minimum monthly payment on time. Ideally, pay more than the minimum to reduce the outstanding balance and interest costs.
Create A Repayment Plan: Develop a repayment plan to clear your outstanding balance gradually. Consider paying more than the minimum if possible.
Monitor And Track Credit Utilization: Keep track of your line of credit usage and stay within a reasonable credit utilization ratio. High credit utilization can negatively impact your credit score.