Unexpected expenses, such as home repairs, car breakdowns, or medical bills, can arise without warning. That’s when a flexible borrowing option, like a line of credit (LOC), may be the right solution.
Unlike a personal loan, which provides a fixed lump sum, a line of credit allows you to borrow only what you need when you need it, up to an approved limit. This makes it a better fit for unpredictable or ongoing expenses.
We’ll explore how a line of credit works, how it differs from other financing options, and which type may best suit your financial needs.
Key Takeaways
A LOC allows you to borrow money up to a specific limit, as needed, paying interest only on what you borrow.
LOCs come in several forms, including personal, home equity, and business lines. They can be secured or unsecured.
The most significant advantage is flexibility. You can borrow, repay, and borrow again as long as you stay within the limit.
Variable interest rates may affect your monthly payments.
What is a Line of Credit?
A line of credit is a flexible loan from a financial institution. It provides you with access to funds up to a predetermined limit, which can be used for various purposes, including daily expenses, emergencies, or larger purchases. Lenders rely on your credit score, existing debt, and current income to determine your borrowing threshold.
Different from personal loans, a LOC allows you to only pay interest on the amount you use. Depending on the terms, some LOCs allow for interest-only payments on the outstanding balance during a designated draw period, after which principal repayments are required. If your limit is $10,000 and you only need $3,000 for now, that’s all you borrow, and that’s all you will be charged interest on.
The type of LOC you choose affects your credit limit. A secured LOC, backed by collateral, allows you to access larger amounts. With an unsecured LOC, your limit depends mostly on your creditworthiness.
How Does a Line of Credit Work?
A LOC acts as a financial safety net. It gives you access to funds on an ongoing basis without requiring reapplication as long as you stay within your limit.
Before approving a LOC, the lender assesses your creditworthiness. This evaluation includes your credit history and score, income stability, and existing debts to determine your borrowing capacity. Secured LOCs may offer higher borrowing limits than unsecured options.
For example, if you have a $10,000 credit limit and borrow $3,000 to fix your car, your available credit is reduced to $7,000. You will only pay interest on the borrowed $3,000. Each month, you'll need to make at least the minimum monthly payment, which typically covers the interest charged on the borrowed amount. As you repay it, your available credit increases.
Additionally, if you have a strong credit profile, you may qualify for a higher maximum limit. This provides extra financial flexibility when unforeseen expenses arise.
What are the Common Types of Lines of Credit?
There are several types of LOCs you may qualify for, depending on your situation and needs. Lines of credit typically fall under three categories.
1. Personal Line of Credit
In this case, funds typically go to personal needs, such as repairs or education. You borrow as needed, up to your approved limit.
Like any other LOC, the lender will do a thorough credit check on you. The amount you can borrow depends on the results of this check. If the lender determines that your financial standing is solid, you may qualify for an unsecured line of credit without the need for collateral.
2. Home Equity Line of Credit (HELOC)
A home equity line of credit is a secured LOC that allows you to borrow against your home’s equity. Equity is the difference between your home’s value and the remaining balance on your mortgage. A HELOC is an attractive option because of its benefits, which include:
Lower interest rates than regular lines of credit (Prime + 1%)
Tax-deductible interest when used for home renos
Interest-only payments during the draw period
Access up to 80% of your home's value minus your mortgage balance
3. Business Line of Credit
A business line of credit is designed to help businesses manage cash flow and cover short-term expenses. Similar to a personal LOC in structure and purpose, it allows businesses to access funds when needed up to a certain limit. The limit is determined by business creditworthiness and, in some cases, collateral.
A business LOC typically charges lower interest rates than business credit cards. New businesses can also qualify if they meet specific requirements.
Pros and Cons of a Line of Credit
Pros | Cons |
You can borrow money as needed and only pay interest on the amount used. | LOCs typically have variable interest rates; your payments can increase due to prime rate fluctuations. |
Once you repay the borrowed amount, the funds become available again. | Lenders may lower your limit if your financial situation worsens or market conditions change. |
Secured lines of credit often have lower rates than credit cards or personal loans. | If you choose a secured line of credit and can’t make payments, you risk losing the collateral. |
Responsible use can improve your credit score. | High credit utilization or missed payments can hurt your credit score. |
A LOC provides quick access to cash for unexpected expenses like medical bills or car repairs. | Paying only the minimum payments can lead to long-term debt due to accumulating interest. |
A line of credit helps businesses manage uneven income or cover short-term expenses like payroll or inventory. | Lenders have strict assessment criteria. |
Interest on HELOCs used for home improvements may qualify for tax deductions, subject to local laws. | Some LOCs, such as HELOCs, have a limited draw period. |
Funds can be used for almost any purpose, unlike loans that are restricted to specific uses (e.g., auto loans). | Variable rates, repayment phases, and fees can make managing a line of credit confusing for first-time users. |
How Much Are Line of Credit Interest Rates?
Lenders calculate interest rates on lines of credit daily. For example, with a personal LOC at a 13% annual interest rate, you'll need to find the daily rate first to calculate how much the debt will cost you each day it is active. So, let’s divide 13% by 365 days for a daily rate of 0.036%.
13% ÷ 100 = 0.13
0.13 ÷ 365 ≈ 0.00035616
0.00035616 × 100 = 0.035616%
0.035616% ≈ 0.036%
If you borrow $3,000, the interest payable each day will be $3,000 x 0.036% = $1.08. Assume that you pay back the outstanding balance after 30 days. The total interest payable will be $32.40 ($1.08 x 30 days).
These loans also typically carry small fees. For example, at Innovation, there’s an annual fee of $25 for personal lines of credit, which is significantly lower than credit card fees, which can be as much as $150.
How to Get a Line of Credit
Lenders often closely evaluate you when approving a LOC because this is not a regular loan. They must be sure that you can handle revolving credit responsibly.
To apply for an Innovation personal LOC, you need to meet the following eligibility criteria:
You are a Canadian resident (excluding Quebec)
You are at least 18 years old
You have an unexpired government-issued photo ID (like a driver's license)
You have a Social Insurance Number
New members need $5 for a member share
To qualify, you will have to provide a set of documents to determine your creditworthiness. For example, if you’re interested in a HELOC, you have to provide:
Proof of income (recent pay stubs or tax returns)
Bank statements
A list of your assets and debts
Property tax assessment or a professional appraisal
Mortgage statement
Before you fill out the application form or gather the relevant documents, you need to prepare carefully to ensure that you choose the correct type of LOC. Let’s break down the application process into steps:
Step 1: Determine why you need the loan. Is it for an emergency expenditure, to repair your house, or to settle a business expense? Also, take this time to weigh a secured vs. unsecured line of credit to see which one is more appropriate.
Step 2: Compare lenders to find the most competitive offer. Consider pre-qualification options if available.
Step 3: Gather all documents you may need to present to the lender.
Step 4: Apply.
Step 5: Wait for approval.
Step 6: Review the offer. If approved, check the limit, interest rate, repayment schedule, and applicable fees.
Step 7: Accept the terms and access the funds.
How Can You Use a Line of Credit?
Having access to revolving credit can be very convenient. But like any financial tool, a line of credit is best used when it makes the most sense. Some of these cases include:
Home Renovations
Sometimes, you want to make house repairs or upgrades like adding a deck. A home equity line of credit may be the perfect solution to get the project underway.
A HELOC covers any unexpected costs that could have otherwise stalled the project. You may also qualify for tax deductions. This advantage, combined with lower interest rates, makes a HELOC an excellent choice for financing home renovation projects.
Emergencies
You can’t prepare enough for the times when life throws unexpected costs your way. If, for example, your home’s heating system suddenly stops working in winter, no lender can process a personal loan fast enough! A line of credit can help cover these sudden expenses.
Business Cash Flow
Sometimes, business is slow, but your suppliers can’t wait for it to pick up. You can get a business line of credit to bridge this gap as you wait for customers to make payments.
We’re here to help!
A line of credit can be a lifesaver when life hits you with unexpected expenses. But it also involves financial obligations like any other loan. So, borrow responsibly and repay promptly to maintain your healthy credit score.
Not sure which line of credit is right for you? Our experts are here to help. Get in touch, and we'll guide you through your options.