What to know about lines of credit

What is a line of credit?

A line of credit is a type of loan that gives you access to a predetermined amount of money. Once you are approved by your financial institution, you can access the funds easily using your debit card, online or at an ATM. 

Advantages and drawbacks

The interest rate on a line of credit is generally lower than other credit solutions. This lower interest rate may allow you to pay back the borrowed funds more quickly.

Good to know: Unlike a personal loan, you will pay interest only on the amount you use, not on the entire loan.

In addition to providing flexibility, a line of credit can be used as an emergency fund. This is especially useful if you don’t already have a safety cushion or don’t have access to your cash because your money is tucked away in an RRSP, for example. Keep in mind, however, that if you take a long time to pay off your balance, the interest will accumulate.

A line of credit allows you to use the funds you need, up to the agreed-upon limit. Depending on the lender’s terms, you will only have to pay either the current interest on the loan each month or a predetermined percentage of your balance. You can then pay off your balance at a pace you find comfortable. Again, if you take your time, the interest will accumulate, increasing the amount you have to pay back.

How does a line of credit work?

You can use all the funds in your line of credit, up to the credit limit set by the bank. Not using it? No interest will be charged, and it will still be there for you when you need it. A line of credit can be a reassuring safety cushion to have.

Calculating the interest

Interest on borrowed funds is calculated on a daily basis, starting from the first day the funds are used.

This example will help you understand how the calculation works:

• Your annual interest rate is 6%. If you divide it by 365 days, the daily rate is 0.0164383%.
• If you borrowed $5,000, you will pay $0.82 in interest per day.
• If you take 30 days to pay back the entire amount, it will cost you $24.60 in interest charges.
• If you take 60 days, it will cost you $49.20, etc.

Paying back your line of credit

Each month, you will receive a statement for your line of credit. It will show you the minimum amount you need to pay back. Usually, the amount due is interest only, but it can also be a predetermined percentage of the balance. Be aware that this payment cannot be made from your line of credit, so you will need to leave room in your budget to cover this amount.

You can then pay off the balance at a frequency that suits you, based on your budget and the interest that will be added to your outstanding balance.

Good to know: Keep in mind that if you only pay the interest each month, you are not paying down the principal you borrowed. This means that you could carry the debt for a very long time and ultimately incur significant interest charges. 

Since interest is calculated on a daily basis, the sooner you pay off your balance, the better. 

A good credit history is key

When you ask your financial institution for a loan or line of credit, they will look at your credit history and credit score. Your bank will be able to see your past payments – in other words, whether you are a good payer – and how much of a risk you represent as a borrower.

If you have a good credit score, your bank may offer you an attractive interest rate. If you have a lower credit score, on the other hand, your chances of getting a line of credit may not be as good, but still possible in some cases. If you are approved for a line of credit and your credit score is lower, your interest rate may be higher.

What are the different types of lines of credit?

There are several types of lines of credit to suit different needs. Here are the main ones.

Home equity line of credit

If you own a home, you may have access to a home equity line of credit. In this case, the line of credit is secured by your home, which means it acts as security for the lender, who may grant you an attractive interest rate. You can apply for it at the same time as your mortgage, which will save you an extra visit to the notary, or at a later point.

How much can you get? Generally, the amount varies depending on the equity in your home, which is the market value of your property minus your mortgage amount. The credit can be as high as 65% of your property’s purchase price or market value.

For example, if you purchased a single-family home valued at $360,000, the home equity line of credit could be as high as $234,000.

This type of line of credit can be taken out alone or combined with your mortgage. If the latter, the credit available increases as you pay off your mortgage, until you reach your credit limit.

The home equity line of credit may be appropriate for:

• Renovations to your property
• Purchasing an expensive item such as a car, boat, etc.
• Consolidating loans or credit card balances with higher interest rates, etc.

Personal line of credit 

You don’t have to be a homeowner to obtain this type of line of credit, since it doesn’t have to be secured by real estate. On the other hand, its interest rate will generally be higher than a home equity line of credit but lower than a credit card. A personal line of credit may be appropriate for:

• Paying for a trip
• Covering unexpected expenses
• Building a safety cushion, etc.
• Contributing to a registered retirement savings plan (RRSP)

Expert tip: Before contributing to your RRSP using your credit, it’s a good idea to do some calculations. Make sure that this investment strategy makes sense for you, taking into account your ability to repay and the monthly interest you could be charged.

Student line of credit

Students can also take out a line of credit specially designed for them. For example, only the interest, not the principal, is payable for the duration of full-time studies. This line of credit is convenient for:

• Covering educational expenses
• Buying textbooks
• Paying rent, etc.

How does a line of credit compare to other types of financing?

Other types of financing such as loans and credit cards also have their uses. So how do they compare to a line of credit?

Line of credit vs. personal loan

• A personal loan must be paid back in fixed monthly amounts over a predetermined period of time, from a few months to a few years. This is a good option if you prefer predictable repayments.
• With a loan, unlike a line of credit, you won’t be able to reborrow the amounts you pay back.
• Aside from the interest due each month, you can pay back the line of credit at a frequency that suits you best. This option requires discipline, however.

Line of credit vs. credit card 

• Interest on a line of credit is calculated from the first day of the loan. With a credit card, you have a 21-day grace period before it starts to accrue.
• Credit cards often provide access to rewards programs and other benefits (cashback, points, insurance).
• Credit cards have a higher interest rate than a line of credit. 

How do I get a line of credit?

You can apply for certain lines of credit directly online, but the best way is to contact an advisor at your financial institution. Our experts will help you choose the line of credit that best suits your situation.

Would you like to discuss this with us? Contact your National Bank advisor or your wealth advisor at National Bank Financial. Don't have an advisor?