How does interest work on a line of credit?

When you have a line of credit, you can borrow up to the pre-set limit to buy whatever you want, like furniture, car repairs, home renovation projects, a new car, or a house. It can be a great credit account, so you have more flexibility when shopping and managing your portfolio.

Whether you have an existing line of credit or are considering applying for one, there are a few features to understand and consider to ensure it makes sense for your situation. After all, you don't want to burden yourself with more credit than you can handle.

Like any credit account, interest plays an important role in a line of credit. Understanding how interest works on a line of credit ensures you know the financial responsibilities of borrowing money from and paying it back.

What is a line of credit?

A line of credit is a loan issued by a financial institution, such as a bank or credit union. You can borrow as much money as you want up to the pre-set limit. You don't need to use the funds for a specific purpose, and you can pay back the funds anytime. You may need to pay a registration or administration fee to use your line of credit.

How does a line of credit work?

Financial institutions give you a pre-set limit on your line of credit. You can borrow funds up to the limit to make different purchases. Like a credit card or any loan, there's an interest rate associated with your line of credit. If you don't use your line of credit, you don't have to repay any money or pay any interest. Interest charges occur from the day you withdraw cash from your line of credit to the day you fully repay the borrowed amount.

You can access your line of credit easily using your debit card, at an ATM, or on your online account. You can also access your funds by writing a check from your line of credit, paying a bill through telephone or online banking, or transferring money from your line of credit to your checking account.

Secured vs. unsecured lines of credit

A line of credit can be secured or unsecured depending on what you apply for and what the financial institution approves. The difference between an unsecured vs. secured line of credit is that a secured line of credit is backed by collateral. The collateral can be your house, car, or something else. Since financial institutions take on a certain level of risk when you borrow money, the collateral offers security to the lender. The lender can take the collateral if you default on your payments. A secured line of credit typically has a lower interest rate.

An unsecured line of credit isn't backed by collateral. It can be trickier to qualify for one as the lender takes on significantly more risk when you borrow from an unsecured line of credit. They may only approve borrowers with high income and credit scores. Since there's more risk with an unsecured line of credit, the interest rates are also typically higher.

Different types of lines of credit

Home equity line of credit

A home equity line of credit (HELOC) is a type of secured line of credit with revolving credit backed by the equity in your home, which is the amount of your home you own. For example, if you have a home worth 1 million dollars and a mortgage worth $400,000, you own 60% or $600,000 of your home. A home equity line of credit lets you borrow money against your home's equity, and the lender can seize your home if you default on payments.

HELOCs have draw periods typically between five and 15 years in which you can borrow money. You're only required to pay interest on your borrowed funds during the draw period, and your repayment period starts once the draw period ends. Since a HELOC is secured against your home, the credit limit tends to be higher.

Personal line of credit

A personal line of credit gives you access to funds immediately and is a type of unsecured line of credit. You can use the funds for whatever you want, and they are useful if you have to make big purchases or want to consolidate high-interest debt. With no collateral to back the money borrowed, lenders take on more risk whenever they issue a personal line of credit. As a result, the interest rates on a personal line of credit are typically higher than on a HELOC. The interest rate may go up or down, and your credit score can influence the rate you get.

Student line of credit

A student line of credit helps fund all or parts of your post-secondary education. Students typically need proof of enrolment from a recognized Canadian post-secondary institution and a co-signer, such as a parent or legal guardian. You can repeatedly borrow from your line of credit up to the pre-set limit to pay for school-related expenses, such as tuition and textbooks. A student line of credit may have a lower interest rate than government student loans, but the repayment period for your line of credit starts immediately.

Personal loan vs. personal line of credit

A personal loan and a personal line of credit are both credit accounts that can lend you funds to use today and repay in the future.

You borrow a specific amount for a personal loan to use. For example, you can take out a $10,000 personal loan to use towards buying a car. You apply for a personal loan every time you want to borrow money. A personal line of credit is a revolving credit line, so you apply once and continuously borrow funds up to the credit limit. Your credit limit resets as long as you pay back the borrowed money.

Personal loans have fixed or variable interest rates, while personal lines of credit only have variable interest rates. You repay your personal loan in installments, which include the principal and interest, and you can choose from weekly, bi-weekly, semi-monthly, and monthly payments. With a personal line of credit, interest is charged on the amount borrowed only, and you repay both at the end of the term.

If you want more flexibility and the option to borrow money repeatedly, you can choose a line of credit instead of a personal loan. However, if you only have a one-time purchase, you may benefit from a personal loan instead, as they typically have lower interest rates and are easier to manage.

Advantages and drawbacks

There are pros and cons to lines of credit. While they give you the flexibility to borrow money for ongoing purchases, it takes good credit management skills to use it responsibly and pay off any outstanding balance on time.

Pros of a line of credit

Here are some pros to choosing a line of credit over other types of credit:

• Interest rates on lines of credit tend to be lower than personal loans and credit cards

• Flexible repayment structures to pay off your line of credit whenever you want

• Interest charges only on the amount you borrow

• Financial institutions may allow you to transfer overdraft to a line of credit to avoid fees

• Access and repay your line of credit in many ways

Cons of a line of credit

Here are some potential cons of getting a line of credit:

• Easy access to funds can lead to overspending and too much debt

• Outstanding balances can lower your credit score

• You risk losing your collateral if you default on payments on a secured line of credit

• Variable interest rates can increase at any time and make your monthly payment more expensive

Line of credit interest rates in Canada

The interest rate on a line of credit fluctuates based on the prime rate set by the lender, the policy rate from the Bank of Canada, plus a percentage. A secured line of credit typically has a lower interest rate as the collateral provides security to the lender in case you default on payments. Unsecured lines of credit usually have higher interest rates as there is no collateral to act as insurance for the lender. Your interest rate depends on certain criteria, such as income, personal assets, and credit score.

Comparing lines of credit to other types of borrowing

Besides a line of credit, you have other options for financing your purchases.

Credit card

Many Canadians use a credit card to make purchases online and in-store. They offer a variety of perks, like cash back, points, insurance coverage, and travel incentives. You can spend up to your credit limit each month as long as you repay your balance on time or face interest charges. The credit card interest is calculated based on the outstanding balance, the annual percentage rate (APR), and the period for which interest is calculated. You may be able to negotiate the credit card interest rate if you provide evidence of good financial behaviour and stable income.

Personal loans

Personal loans are a one-time fixed amount you get from the lender. You have a fixed payment schedule to repay the principal and interest owed. For example, you can have monthly interest and principal repayments. A personal loan typically has a lower interest rate and may be a good alternative if you only need an amount of money for a specific purchase.

Second mortgage

A second mortgage is a loan secured by a property and the primary mortgage. It can be a good option for financing your home if your original mortgage has a lower fixed interest rate you want to keep locked in.

Getting a line of credit from KOHO

Build your credit with KOHO in one of three easy ways. You can get a KOHO line of credit, a secured line of credit, or supercharge your credit with a combination of both. You have guaranteed approval, and there's no interest or applications. Regardless of which option you choose, you can access your free credit score and financial coaching.

If you want an alternative to a line of credit, you can opt for a virtual credit card. Manage your spending easily and access funds instantly by linking your card to your phone. We offer Cover, a subscription-based overdraft protection coverage, giving you up to $250 interest-free cash advance for unexpected expenses.

Learn more about how KOHO can help you spend responsibly, save money, and build credit, all while earning interest and maximizing your rewards.