Choosing the best line of credit for your needs does not need to be complicated.
Here are the top 3 choices right now for Canadians.
What is a personal line of credit?
A personal line of credit is a revolving credit product that allows you to borrow cash when you need it up to a predetermined limit.
You only pay interest on the money you borrow, for the time you borrow it.
As with any revolving credit product, you can draw funds repeatedly.
Each principal payment you make, less interest, replenishes your available credit.
If a borrower has a line of credit with a limit of $10,000 and draws down $3,000, then the remaining availability is $7,000.
Subsequently, if the borrower repays $500, availability then goes up by the equivalent amount to $7,500.
You can use a personal line of credit to finance large expenditures, such as a home renovation or vehicle purchase, or pay for everyday expenses when you find yourself short on cash.
It can also be a valuable tool for consolidating high-interest debt.
The way you manage your personal line of credit will have a direct impact on your credit score.
Negative financial consequences can ensue if you consistently fail to make timely payments.
Let’s explore in detail how a personal line of credit works and what to be aware of if you plan to apply for one.
Did You Know?
Certain lines of credit are non-revolving products, meaning once you repay money you’ve borrowed, you can no longer access it in the future.
How interest works on a line of credit
A line of credit is a variable rate financial product, meaning that the rate you pay on funds you borrow can fluctuate over time.
Your rate rises and falls in tandem with changes in the prime rate.
Your lender will use the prime rate as a benchmark when assigning the rate on your line of credit.
If you possess a stellar credit score and have a consistent income, they may set you a rate equal to the prime rate.
However, it’s pretty standard for a lender to add a few percentage points on top of the prime rate.
This amount is based on various factors, such as the credit limit you’re seeking, the institution’s terms and conditions, and your financial profile which includes your current debt obligations, income, credit score, and other factors.
Traditional lenders typically require applicants to have a minimum household income between $35,000 and $50,000 to be approved for a line of credit.
Each lender has its policy when determining your actual interest charges for each billing cycle (which spans a month).
A common method is to calculate interest on your daily balance.
This calculation involves multiplying the outstanding balance at the end of each day by the current rate in effect before dividing it by 365 days.
Each day’s accrued interest for one billing cycle is then added together and charged to your account.
You can view this charge in your monthly statement.
Interest on a line of credit usually compounds monthly.
Using and paying back line of credit
With a personal line of credit, you have the freedom to access cash at your discretion.
You’ll be charged interest only on the amount you borrow.
When you pay back a portion of your principal, the amount is added back to your available credit for future use.
To access money through your line of credit, you can write a cheque, make an ATM withdrawal, or conduct transactions using your online banking.
Interest accrues immediately after you draw cash from your account and continues to do so until you pay back the principal.
Depending on the lender’s policies, you may also be responsible for various fees, such as administration fees, registration fees, late fees, over-limit fees, and annual maintenance fees.
Your lender will issue you a statement with your transaction history, interest, and balance owing at the end of every month.
Unlike a personal loan, there may not be a fixed payment schedule you must abide by for money you borrow through a line of credit.
However, most lenders will have a minimum amount to be repaid each month that varies from lender to lender.
You must be mindful of not falling behind on these minimum payments, and in general, are obligated to pay the minimum payment by a specific date.
For example, your contract’s conditions may stipulate that you pay either 2% of your outstanding balance or $50, whichever is higher.
Other lenders allow interest-only payments for a limited time, after which you must begin covering your principal.
Most lenders grant you considerable flexibility in shaping your repayment schedule since a personal line of credit is an open-ended loan product.
Besides making a minimum payment as outlined by your lender, you can generally draw funds and repay funds as you wish.
Some financial institutions offer balance protection insurance for your line of credit account, which can cover your payments should you lose your job due to a severe illness or disability.
Unsecured vs Secured line of credit
A secured line of credit necessitates you put up a personal asset as collateral.
The asset protects the lender in case you default on your payment obligations.
Due to the loan being lower risk, the lender can usually offer larger credit limits and lower interest rates.
For the same reasons, a secured line of credit has more lenient eligibility criteria.
An unsecured line of credit is not backed by a personal asset.
Lenders rely on your general creditworthiness to evaluate whether to extend you the loan.
Since the lender is more financially vulnerable to default, they will compensate for this risk by assigning you a higher rate.
Unsecured lines of credit are typically more challenging to qualify for than secured ones.
Using a line of credit to pay off a credit card
A personal line of credit can help you alleviate the financial burden associated with high-interest debt products like credit cards.
By consolidating your existing, high interest credit card debt, you can better manage your payments and keep more money in your pocket.
Suppose the interest on your credit card is 18.99% credit card rate and your line of credit is 6.99%.
In that case, you can save immensely on interest charges by paying off your credit card balance with your line of credit.
Consolidating your debt in this manner would be a financially savvy move.
However, if the rate on your line of credit is steep, consolidating might not be worth the effort due to interest rate risk.
In addition, freeing up your credit card balance through consolidation could entice you to rack up more credit card debt, leaving you worse off than before.
If you have collateralized an asset you own, your lender can also seize it if you subsequently fail to service your line of credit payments.
Pros of a Personal Line of Credit
- Draw funds whenever you wish
- Only borrow what you need
- Credit limit replenished when you pay back your principal
- Flexible payment schedule
- Lower interest rate than credit cards
- Interest charged only on the amount you borrow
- May be allowed to make interest-only payments
- No prepayment penalties
Cons of a Personal Line of Credit
- Requires discipline and attentiveness to managing debt
- You could lose your home or another personal asset you put up as collateral (applies only to secure lines of credit)
- Risk of increased interest costs if the prime rate rises
- Potential fees (annual fee, administrative fee, etc.) to pay, which increases the total cost of borrowing
- Need a good credit score to qualify
- Late payments and high credit utilization will negatively impact your credit score
Frequently Asked Questions
- Is it hard to get a line of credit?
It can be challenging to obtain a line of credit with favourable terms and a low interest rate. Traditional lenders, such as banks and credit unions, typically offer low-rate lines of credit to individuals with high credit scores and a reliable income.
It’s relatively easy to get approved for a line of credit in the alternative lending market, but you must be prepared to commit to a steep interest rate.
- What credit score do you need for a line of credit?
You usually need to have a “good” to “excellent” credit score to be eligible for a line of credit from a bank or credit union. A credit score between 660 and 724 is considered “good,” 725 to 759 is “very good,” and “excellent” is a score of 760 or higher.
You can still obtain a line of credit if you have a poor credit score (any score below 660) in the alternative lending market. However, lenders operating in this sphere often charge exceedingly high rates.