Line of Credit Pros and Cons

A line of credit is a type of loan that works similar to a credit card, allowing you to borrow money up to a set limit without needing to specify how you’ll use it. You can borrow as little or as much as you need, up to the maximum limit. This makes it a flexible borrowing option. Lines of credit can be used for home renovation projects, daily expenses, or even to pay down high-interest debt.

Unlike with personal loans, you can use the line of credit repeatedly while it is active. You only pay monthly interest on what you borrow, and the interest rate is often low. For example, if you’re approved for a $15,000 line of credit, but the project you needed the money for costs $9,000, then you’ll only pay interest on the $9,000 you took out.

Plus, interest starts adding up only when you use the credit line, either by making a purchase or withdrawing cash. However, you can only use the line of credit for a certain period, and you might need to reapply to extend it. Once this period ends, you’ll start repaying the borrowed money plus interest.

There are many benefits to having an open line of credit, but there are also risks. Here are the pros and cons of having a line of credit.

Pros of having a line of credit

There are many benefits to having a line of credit, including:

Lower interest rates

A line of credit typically has access to lower interest rates in Canada than other types of credit, like a credit card. However, this depends largely on your credit history and score.

Only pay interest on what you borrow

With lines of credit, you won’t need to make monthly payments on the money you’ve borrowed until the end of the draw period. You’ll only pay the interest.

However, interest is only charged on the amount you’ve actually withdrawn, not on the total credit limit. For example, if your credit limit is $15,000, but you’ve only taken out $9,000, you only pay interest on the $9,000.

Plus, a personal line of credit typically has a long draw period, often lasting several years, before you need to start paying back the principal.

Access to money as you need it

A line of credit allows you to take out money as needed without having to request a specific amount in advance. It can be a better option than a personal loan if you have fluctuating expenses.

For example, during a home renovation project, unexpected expenses often come up. If you applied for a personal loan for your project, you may find out you won’t have enough to cover these new expenses.

On the other hand, with a line of credit, you can withdraw only what you need and then come back later for additional funds to cover these unpredictable expenses.

Access to a revolving credit limit

When you’re approved for a line of credit, the financial institution gives you a set limit you can borrow from repeatedly, either all at once or in parts. Then, just like with a credit card, as you pay back the money you borrowed (within the draw period), it becomes available to borrow again.

Protection from overdraft and NSF fees

Some financial institutions will let you connect a line of credit to your checking account. This means that if an unexpected payment, like a high utility bill, comes out of your account and puts you in the negative, your line of credit can cover your overdraft.

Builds your credit history

Lines of credit usually affect your credit report and credit score more quickly and significantly than other types of loans. As long as you consistently make your interest-only payments on time each month, this positive behaviour will be reported to Canada’s credit bureaus, helping to improve your credit score. Having a strong credit score makes it easier to apply for things like unsecured credit cards and mortgages and can even help you find a good job.

Easy to use

Lines of credit are very easy to use. Once you’ve been approved, you can access money from an ATM, at a branch of your financial institution, or through online, mobile or telephone banking. Some institutions also offer access by writing a line of credit cheque.

Cons of having a line of credit

While there are many benefits to having a line of credit, there are still a few risks you need to be aware of, including:

Variable interest rates

One major drawback of a line of credit is the interest. Unlike personal loans, where you can get a fixed interest rate, most lines of credit have variable interest rates that can rise or fall with the economy, making monthly payments less predictable.

The interest rate you pay will vary depending on the financial institution and the economy. It will also depend on whether your line of credit is secured or unsecured and your credit score.

It can be harder to qualify for than a personal loan

Since lines of credit are typically offered by banks rather than alternative lenders (though some alternative lenders do provide them), they often have strict requirements and can be harder to obtain compared to personal loans.

It may come with various fees

Some lines of credit may have fees, such as registration or administration fees. Some financial institutions also charge annual or monthly maintenance fees and levy inactivity or cancellation fees. Furthermore, there may be transaction fees every time you make a withdrawal and missed or late payment fees.

Impacts credit use and credit score

Although you only pay interest on the money you actually use, the entire credit line affects your debt service ratio. The more you use, the more it impacts your credit utilization. Both your debt service ratio and credit utilization directly affect your credit score.

Easy to overspend

If you don’t manage your loan carefully, you could end up with significant debt. Because the money is easily accessible, it can be very easy to borrow more than you need or overspend. Then, if you reach a point where you cannot afford to pay back what you owe, your credit score will start to drop.

Secured vs. unsecured lines of credit

A line of credit can be secured or unsecured. Secured lines of credit usually have lower interest rates, while unsecured ones have slightly higher rates. A secured line of credit is less risky for the lender because it requires collateral, like a home. The most common type is a home equity line of credit (HELOC), which uses your house as collateral. This helps reduce borrowing costs but means if you can’t repay, you could lose your home.

An unsecured line of credit doesn’t require collateral, making it riskier for the lender. As a result, it often has higher interest rates and stricter credit requirements. Common types of unsecured credit lines include personal and student lines of credit. Personal lines of credit allow you to borrow money for big expenses as needed rather than getting a lump sum. A student line of credit helps pay for college or university expenses.

What are the different types of lines of credit?

There are several types of lines of credit, but the most common ones are home equity, personal, business, and student lines of credit.

Home equity line of credit

If you own a home, you might be able to get a home equity line of credit (HELOC), which uses your home as security. By using your home as collateral, it can give you a better interest rate. You can apply for it when you get your mortgage or at a later date.

The amount you can borrow depends on your home’s equity, which is the market value of your home minus your mortgage balance. You can usually borrow up to 65% of your home’s value. For instance, if your home is worth $1,000,000, you could get a home equity line of credit up to $650,000.

This type of credit can be separate or combined with your mortgage. If combined, the available credit increases as you pay down your mortgage up to your credit limit. Most HELOCs have a designated draw period, often lasting up to 10 years.

During this period, the borrower can repeatedly use, repay, and reuse the funds. Since HELOCs are secured, they generally have lower interest rates compared to personal lines of credit.

Personal line of credit

This is an unsecured line of credit, meaning there’s no collateral to back it up. Because of this, you need a higher credit score to qualify. Personal lines of credit usually have lower credit limits and higher interest rates. However, most banks offer these indefinitely. They are ideal for expenses like vacations, small home renovations, or unexpected costs like a broken air conditioner or furnace.

Business line of credit

These are like a personal line of credit but designed for businesses. The bank looks at the company’s market value, profitability, and risk. A business credit line can be either secured or unsecured, depending on the amount requested.

Student line of credit

A student line of credit works like a regular line of credit, allowing you to borrow money, but it’s tailored specifically for students. Generally, the interest rates on a student line of credit are lower than those on a traditional line of credit.

It’s meant to help cover expenses related to post-secondary education, such as tuition, textbooks, and student housing. To be eligible, you must be a Canadian citizen or permanent resident enrolled in a certificate, apprenticeship, degree, or diploma program at an eligible Canadian post-secondary school.

What credit score is needed for a personal line of credit?

In Canada, your safest bet is to have a credit score above 670, in the range of a good or excellent credit score.

Although a line of credit is different from a personal loan, it is still a credit product. As such, lenders will want to check the credit scores of potential borrowers. They will then use the credit scores to judge how likely a person is to repay a loan on time and in full.

Most lenders will be reluctant to offer a line of credit to those with bad credit or a history of not repaying loans and more eager to offer a line of credit to those with good or excellent credit scores.

While it’s possible to get a line of credit with a poor or fair credit score, it’s certainly more challenging. You’ll need to look for creditors who offer lines of credit to people with poor or fair credit scores, or you may need to ask someone with a good or excellent credit score to co-sign your line of credit.

Financial institutions are more willing to approve a loan with a co-signer because if the owner of the loan defaults on payments, then the co-signer will be required to repay the line of credit.

Does a line of credit affect your credit score?

Absolutely. There are a few different ways it can affect your credit score.

Like credit cards, a line of credit is considered revolving debt and affects your credit score in a similar way. Making full and on-time payments will positively impact your credit score and help you build up a good credit history because payment history has the biggest impact on your credit score. However, if you make a late payment or you’re missing payments altogether, this will negatively affect your credit score.

In addition, your line of credit now counts toward your credit utilization rate. Credit utilization is the percentage of available credit you’re using. If you use more than 30% of your total credit, your score will decrease. However, if you stay below 30%, it will increase. So keep this in mind when deciding how much money from your line of credit you want to borrow.

Finally, since your credit score is a determining factor when applying for a line of credit, it requires a hard credit check on your credit report, which can temporarily lower your credit score.

Is it a good idea to have a line of credit?

It all depends on what you’re considering using the line of credit for. For example, if you are currently making several high-interest payments on other debt, you can use a personal line of credit to help you consolidate your debt.

This means using a loan to pay off all your current debt at once, like your credit card bills. This way, you only have one monthly payment to manage and, sometimes, a lower interest rate, as personal lines of credit often have lower interest rates than credit cards.

Another good reason to open a line of credit is if you know something big is coming up, but you don’t know how much it’ll cost. For example, say you’re planning to renovate your kitchen; everyone knows that renovations end up costing more than the initial estimate.

If you opt for a personal loan and your renovations end up costing more than you borrowed, you’ll be stuck with having to apply for a second loan. But with a line of credit, you can borrow as much as you need up to the maximum limit, making it a more flexible option.

How to open a line of credit

Opening a line of credit is similar to getting a personal loan, but there are some differences. Here’s how to do it:

1. Research line of credit options: First, decide which type of line of credit you need and check if you meet the minimum requirements. For example, for a HELOC, you need at least 20% equity in your home.

2. Compare lenders: Once you know the type of line of credit you want, compare offers from different lenders. Start with your bank since they might offer a rate discount if you have multiple accounts with them. Compare APRs, credit limits, credit score requirements, and fees.

3. See if you’re preapproved: Before officially applying, check if you can get preapproved. This will give you an idea of your chances of approval.

4. Gather necessary documents: When you’re ready to apply, you’ll need financial documents like proof of income, bank statements, and mortgage payment records, depending on the line of credit. Have these ready beforehand.

5. Apply: Finally, apply for the line of credit online, through a mobile app, or in person at your financial institution. If approved, you’ll receive instructions on how to access your line of credit.

Open a line of credit with KOHO today

KOHO is a company that helps you improve your credit score. They offer a revolving account with a line of credit or secured line of credit you can use as needed. You have guaranteed approval, and there’s no interest or applications. When you make on-time payments, KOHO reports this to credit bureaus, which helps boost your credit score. You also get free access to your credit score.

KOHO also offers a high-interest savings account that earns up to 5% APY on qualifying purchases, and for as little as $2 a month, you can add overdraft protection coverage. Additionally, KOHO offers instant approval virtual credit cards for secure online shopping.