Most of us are quite familiar with credit cards and how they work, but what is a line of credit? How is it different from a credit card, and when should it be used instead? Here’s what you need to know about lines of credit vs. credit cards and when to use each one.
What is a line of credit?
A line of credit is a loan that allows you to borrow money for any reason up to a limit, subject to an interest rate. You can use however much money you need (up to the limit), and you only pay interest on the amount that you borrow. There is no deadline to pay back your line of credit, which means you can pay it off as quickly or slowly as you like, as long as you make your minimum monthly payments.
How does a line of credit work?
To open a line of credit, you will have to talk to your bank or financial institution. Ask about any fees they’ll charge to open the account, such as a registration or admin fee.
Once your line of credit has been approved with a specified limit, you can access the money by:
- Writing a cheque from your line of credit
- Withdrawing cash from it at an ATM
- Using the account to pay off a bill
- Transferring money into your chequing account via online banking (or over the phone)
Every month you will get a statement indicating how much you owe. You’ll need to pay a minimum monthly payment (typically the monthly amount of interest) but, there is no deadline for paying back the full amount. However, only paying the minimum payment means you’ll never pay off this debt.
Interest rates vary depending on the type of line of credit you open but are often variable, which means your rate will change over time. Your credit score may also play a role in establishing your interest rate. People with higher credit scores may be offered lower rates, as they are seen as more likely to pay back the debt.
Types of lines of credit and alternatives
Secured line of credit
For this type of credit line, you use an asset— such as your car— as collateral. If you don’t pay back the loan, your asset can be taken by the financial institution. Since you’re backing your loan with collateral, a secured line of credit typically has a lower interest rate than some other types of credit lines.
Home equity line of credit (HELOC)
This secured line of credit uses your home as collateral. HELOCs often have low interest rates and high credit limits. However, if you don’t pay back your HELOC, you could lose your home, so make sure not to borrow beyond your means.
Unsecured line of credit
This kind of line of credit isn’t backed by any collateral. Personal and student lines of credit usually fall into this category.
Personal line of credit
A type of unsecured credit line that can be used for whatever you wish. Interest rates on personal lines of credit are typically lower than those for credit cards or personal loans.
Student line of credit
This kind of credit line is designed specifically for paying for post-secondary education expenses, including tuition, books, and housing.
Alternatives to a line of credit include personal loans and credit cards. While interest rates vary on lines of credit based on the type and your credit score, they are typically lower than those on loans and credit cards.
Pros and cons of lines of credit
- Often have lower interest rates than credit cards or personal loans
- Allow you to apply once, then have access to the money whenever you need it
- Can be used for whatever you want
- Can help you avoid other fees, such as overdraft fees in your chequing account
- Interest rates vary and can be changed by the lender at any time
- Easy access to money could encourage overspending and lead to financial trouble
- Can take a long time to pay off if you’re only making minimum payments
Line of credit vs. credit card
A line of credit and a credit card work in similar ways, but have a few key differences. Before you choose one over the other, consider convenience, how quickly you will be able to pay off your debt, and how much money you need to borrow.
When to use a line of credit
- When you need a higher credit limit
- When you plan to take longer than a month to pay back a large balance
When to use a credit card
Can a line of credit affect my credit score?
Yes. Opening and using a line of credit can impact your utilization rate, which will affect your credit score. Late payments may also impact your credit.
Can I use a line of credit to pay off a credit card?
Yes, you absolutely can. This strategy could help you move your debt from a high-interest card to a lower-interest line of credit, so you pay less interest as you work on paying off the balance.
Do I need a certain minimum income to qualify for a line of credit?
Typically, you must have a minimum household income of $35,000 to $50,000 to qualify.