All You Need to Know About a Line of Credit
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; interest begins to accrue 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 that you draw from. The bucket has a set capacity, say 1,000 Loonies. You can borrow however many Loonies 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, which will determine your credit limit and variable rate of interest. 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
As mentioned, there are generally no restrictions on how borrowers can spend money from a line of credit. Here are some reasons why you might opt to take one out:
- As an emergency fund
- To pay for home renovations or repairs
- To buy a vehicle, or any other large ticket item
- To consolidate higher-interest debt
- To invest
- For education expenses
- To finance a portion of a home purchase
Line of Credit vs. Loan
There are a few key differences between a loan and a line of credit. A 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 equal 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.
A line of credit, on the other hand, 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 and spend 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 in interest fees with a line of credit if you don’t pay back the money you’ve borrowed on a timely basis.
Types of LOCs: Secured vs. Unsecured Line of Credit
LOCs come in two basic varieties: secured and unsecured.
With a secured line of credit, borrowers use a high value asset that they own, usually a home, as collateral against the loan. Lenders can feel confident that even if a borrower defaults on his or her payments, they can still recover the value of the loan 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, which also makes it harder for borrowers to qualify for. 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). We explain each of these below.
This is the most basic line of credit available to Canadians. Because it is unsecured, there is no risk that borrowers will lose their home or other collateral asset 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.
Similar to a personal line of credit, a student line of credit is unsecured, but is only available to part-time or full-time students enrolled in a recognized post-secondary education institution. The money borrowed from a student line of credit can be used for tuition, books, housing and other living expenses, such as food and transportation.
Unlike with student loans, money borrowed from a student line of credit starts accumulating interest immediately, even if the borrower is still studying. The borrower doesn’t have to start repaying the loan, however, until after they graduate (there may be a grace period of six to 12 months, depending on the repayment terms of financial institution used). If they choose, students can start paying the money back sooner — even while they’re still studying — without penalty.
Home Equity Line of Credit (HELOC)
As a secured line of credit, a HELOC offers relatively low interest rates, usually somewhere around 0.5% to 2% above the lender’s prime rate. To qualify, borrowers 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, borrowers commonly use HELOCs to finance major expenses, such as home renovations, or to access funds for investment. 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 combine a HELOC with a mortgage, which is also called a readvanceable mortgage.
HELOCs can make home ownership more affordable for many Canadians, because they reduce or eliminate the amount of principal that must be paid down each month. That flexibility, however, is a double-edged sword, leaving some borrowers making interest-only payments indefinitely.
According to the Financial Consumer Agency of Canada, about 40% of HELOC borrowers don’t make regular payments against their outstanding principal, and about one-quarter pay only the interest or minimum payment. Because of this, the agency has raised concerns that borrowers may increasingly be at risk of losing their homes if interest rates climb.
To make sure this doesn’t happen, borrowers must pass a stress test to get a HELOC from a bank; other lenders may also use the test to determine eligibility. What this means is that lenders check to make sure borrowers are financially secure enough to make their payments even in the event that interest rates increase by about 2%.
The FCAC also suggests borrowers come up with a clear plan for how they will use and repay money borrowed against their home equity line of credit, and that they avoid borrowing money to cover monthly expenses for any prolonged period.
Is an LOC Right for Me?
To help you decide if a line of credit makes sense for you, here are a list of advantages and disadvantages of this form of borrowing.
- Usually have lower interest rates than personal loans or credit cards
- You pay interest only on the amount you borrow, not the entire line of credit
- Flexibility to pay back the money on your own schedule
- No penalties for paying off your line of credit “early” or “late”
- One-time application process
- May save you money on bank fees, if your bank lets you transfer any overdraft on your regular account to your line of credit
- Interest rates are variable; if they rise you might have difficulty making your payments
- You need to 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 easily available
- Your bank or other 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 future
- With a secured line of credit, you could even lose your home 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.