What is a line of credit?

Portrait of smiling young woman and her mirror image in underground train. She wonders what a line of credit is.Image: Portrait of smiling young woman and her mirror image in underground train. She wonders what a line of credit is.

In a Nutshell

A line of credit gives borrowers flexible access to funds as needed. Unlike a personal loan, a line of credit does not require taking the full amount in a lump sum — you can choose to draw money as many times as the credit limit allows and pay interest only on what’s been borrowed.
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Are you looking for a flexible way to borrow funds? A line of credit could be the answer.

A line of credit is a revolving amount of credit that allows you continual access to funds up to a set limit. Unlike with a personal loan, you can withdraw funds as you need them, instead of having to receive your approved funds as a lump sum.

Once your line of credit’s limit has been set, you can draw as much as you like and pay it back over time. As you pay back what you’ve borrowed, you regain access to those funds for future borrowing.

Unlike some loans, lines of credit do not need to be used for a specific purpose and can usually be paid back on a less defined timeline. You may be able to access the funds at a lower interest rate than you’d get on a credit card, as well.

In this article, we’ll take a close look at how a line of credit works, the two key types, and the pros and cons of using one.


How does a line of credit work?

A line of credit is a revolving form of credit, which means you’re not limited to taking your money in one lump sum. Its flexible nature means that you’re able to borrow up to a predetermined limit as many times as you like.

Unlike a mortgage, auto loan or student loan, you don’t have to use the money you borrow from a line of credit for a specific purpose. You can borrow as much or as little as you need up to your approved limit, for as many reasons as necessary, and then repay the money you’ve borrowed.

At the same time, a line of credit isn’t free money — you’ll be assessed interest on what you borrow. Your interest rate, as well as your credit limit, may be affected by your credit scores and reports, and lenders may offer you a higher interest rate if you have a negative credit history.

While many lenders only require interest-only minimum payments on a line of credit, you’ll begin getting charged interest as soon as you withdraw funds and until you pay back that sum. If you never pay back more than the minimum payment on your line of credit, interest will pile up and you could end up with a heap of debt.

Secured vs. unsecured lines of credit

A line of credit can either be secured by collateral or be unsecured. This has a big effect on what lenders offer. 

Secured

With a secured line of credit, an asset that’s used as collateral “secures” the money you borrow from the lender. That asset serves as security if you fail to repay the line of credit according to the loan terms.

A home or car is often used as collateral in these cases, but any item with a value high enough to secure the funds may work. In this scenario, the risk should be clear — if you don’t pay back the money you owe, then the lender can move to take the asset. The main benefit of a secured line of credit is that you’ll typically get a lower interest rate than you’d otherwise be offered on an unsecured line of credit.

A home equity line of credit, or HELOC, is a common secured line of credit. In this situation, the borrower’s home is the collateral. Because homes tend to be especially valuable assets, HELOCs often have a higher limit and lower interest rate than other lines of credit.

Unsecured

With an unsecured line of credit, no assets are put up as collateral, so the interest rate depends largely on information in the borrower’s credit profile.

When setting the limit on your unsecured line of credit, your lender will consider several factors, like your income, any existing debt and your credit reports. According to the Financial Consumer Agency of Canada, lenders usually require a household income of at least $35,000 or $50,000 to approve a line of credit.

Many personal lines of credit and student lines of credit are unsecured. A personal line of credit may be ideal if you need money to consolidate debt. Meanwhile, a student line of credit is money you can borrow for attending college or university. It can be used to help cover related expenses, like books, tuition and student rent.

Pros and cons of a line of credit

While lines of credit can be useful, they are not right for every borrower. Here are a few of their pros and cons.

Pros

  • The interest rate on a line of credit is typically lower than that of a credit card or personal loan.
  • A line of credit offers flexibility, because you don’t have to use the funds for a specific purpose and you can withdraw those funds over a lengthier period of time. Unlike a loan, you don’t have to take all the money at once.
  • If your line of credit is with the same lender where you have your chequing account, you may be able to use it as a backup in case your bank account ever goes into overdraft.

Cons

  • The flexibility of a line of credit makes it tempting to dip into the funds for purchases that aren’t essential. That can get you into serious debt. With a line of credit, discipline is key.
  • The availability of interest-only minimum payments means that it can also be tempting to pay your balance back slowly, potentially leading to a pileup of interest and debt.

Keep in mind that what works for one borrower might not be best for another. Before getting a line of credit, consider the pros and cons, how you’d use it, and whether you’ll have the discipline and ability to pay back what you borrow without getting into too much debt.


About the author: Sean Cooper bought his first house when he was just 27 and paid off his mortgage at 30 in 3 years. An in-demand personal finance journalist, money coach and speaker, h… Read more.