Living in Canada can sometimes feel like a financial juggling act. People deal with bills and unexpected costs, and their income does not quite keep pace. Whether fixing a leaky roof, chasing a start-up dream, or tackling high-interest credit card debt, you need a reliable tool that lets you borrow money on your terms, giving you more freedom than a standard loan, a Line of Credit.
But without a clear plan and understanding of how it works, it can trip you up. This guide from BestMO helps you get it right so that you can use a line of credit to your advantage with confidence.
What Is a Line of Credit?
A line of credit (LOC) is a flexible borrowing option from banks or financial institutions. It allows access to funds up to a set limit. Unlike traditional loans, you only borrow what you need and pay interest on the amount used. Moreover, you also have the option to make interest-only payments until the balance is repaid.
LOCs provide convenient access to financing that can bridge gaps in cash flow timing. Thus, they are used for short-term needs rather than long-term expenses.
How Does a Line of Credit Work in Canada?
Let’s explore “What is a line of credit and how does it work?” within the Canadian financial landscape.
Borrowing and Accessing Funds
Once your line of credit is approved, your bank or lender will set your borrowing limit. You can access the money in several convenient ways, such as:
- Transferring it to your chequing account,
- Using online or phone banking to pay bills,
- Withdrawing cash at an ATM, or even writing a cheque.
You are not restricted to how the funds are used. You could tap into it for emergencies, home repairs, tuition, or to consolidate higher-interest debts.
Calculate the Interest Rate
Interest on a line of credit is charged daily. It means the amount you owe can change quickly depending on your repayment habits. The following is the way interest is calculated:
- Daily rate: Annual interest rate/365 days.
- Daily interest: Amount borrowed * Daily rate
- Total interest: Daily interest * Number of days borrowed.
Minimum payments are often interest-only or a small percentage of the balance. Paying just interest keeps payments low but does not reduce the debt, so pay more when you can.
Revolving Nature
Once you repay part of the balance, that money becomes available to borrow again, similar to how a credit card works. This cycle allows you to manage your cash flow more effectively.
What are the Types of Lines of Credit in Canada?
There are 6 types of lines of credit available in Canada:
Secured Line of Credit
What is a secured line of credit in Canada? This type requires an asset as collateral to lower the lender’s risk, giving you a better interest rate and often a higher limit. If you do not repay, the lender can take the asset. Still, you likely pay less interest, which may save you hundreds over time.
Common collateral includes:
- Your home (for home equity lines of credit)
- Vehicles
- Investments and securities
- Cash deposits or savings
Unsecured Line of Credit
This choice includes most personal and student lines, and does not require any assets as collateral. Because there is more risk for the lender, interest rates are typically higher than for secured lines, but they are still lower than most credit cards.
Approval depends mainly on your credit score, income, and existing debt levels. You can use the funds for nearly any purpose and only pay interest on the amount you borrow.
As a result, it is ideal for those who need financial flexibility without tying the loan to their assets.
Personal Line of Credit
This unsecured option lets you borrow, repay, and borrow again for general expenses, emergencies, or debt consolidation. The plus point is that it requires no collateral.
It usually starts at $2,000, with minimum payments often being 2% of the balance or $50 (whichever is greater). Interest rates are lower than credit cards but higher than secured credit options.
So, it is helpful for home improvements, emergencies, consolidating higher-interest debt, or major life events.
Home Equity Line of Credit (HELOC)
This is a specific secured credit product where your home acts as collateral. It is designed for homeowners who want to access the equity they have built in their property.
HELOCs in Canada typically:
- Start at $5,000
- Higher credit limits, often up to 65% of your home value
- Minimum payments are often interest-only
- Lower interest rates compared to other credit options
With the above features, home equity lines of credit are ideal for large expenses, like home renovations or consolidating other debts.
However, missing payments can lead to serious consequences, like foreclosure. Today, some HELOCs combine mortgage payments and credit lines, which allows more borrowing as the mortgage is paid down.
Student Line of Credit
This option helps cover tuition, books, and living costs for post-secondary students, which can be a helpful complement to student loans and grants. It typically offers:
- Lower interest rates than general credit lines
- Higher limits than most students would otherwise qualify for
- Interest-only payments while in school
- Grace periods after graduation before full repayment begins
Business Line of Credit
Business LOC provides access to funds for managing cash flow, covering operating costs, or purchasing inventory. It differs from personal lines in some ways:
- Often tied to the performance and assets of the business
- May adjust based on accounts receivable or inventory
- Can be secured or unsecured
- Shown on business credit reports, not personal ones
They are beneficial for short-term financing and seasonal fluctuations. Smaller businesses might receive a credit line equal to about 10% of their annual revenue.
How to Apply for a LOC in Canada?
Most banks, lenders, and credit unions in Canada offer lines of credit. You can apply online, by phone, or in person. Before you apply, some important documents are required, including:
- Government-issued photo ID (driver’s license, passport)
- Proof of income: Recent pay stubs, T4 slips, Notice of Assessment, or business financial statements
- Financial information: Bank statements, investment statements, debt information
- Asset documentation: Property assessments or investment statements (for secured lines)
In the case of student LOC, proof of enrollment in a post-secondary institution is commonly required.
What credit score is needed for a line of credit in Canada?
To qualify for a line of credit in Canada, you will typically need a good credit score (usually 670 or higher). Moreover, you need to have a steady income, a manageable debt load, and a positive credit history. Lenders may also assess your employment status, financial assets, and, for secured lines, the value of your collateral. Reviewing your credit report beforehand can help spot and fix any issues that might affect approval.
What are the Advantages of Lines of Credit?
Understanding these key benefits can help you decide whether this borrowing option fits your financial goals.
- Lower interest rates: LOCs typically have lower interest rates than other borrowing methods. While credit cards can charge anywhere from 19% to nearly 30%, personal lines of credit often start closer to the bank’s prime rate plus a small margin. That rate can be under 10% for borrowers with strong credit. It may be even lower if the line of credit is secured.
- Flexible borrowing and repayment: You can avoid paying interest on unused funds. You also have the freedom to repay the borrowed amount at your own pace and reuse the funds as needed, without having to reapply. During periods when cash is tight, most lenders allow you to make interest-only payments, which can offer breathing room.
- Simplified financial management: Instead of juggling multiple loans for different purposes, a line of credit can cover them all. This streamlines your borrowing into one account.
- Potential to save on fees: Some banks waive setup or annual fees, especially if you are an existing customer.
What Are the Disadvantages of Lines of Credit?
While lines of credit are convenient, they are not without risks. There are 4 cons of LOCs to consider:
- Temptation to overspend: Easy access can tempt you to borrow more than you can repay. Without discipline, this can quickly become unmanageable.
- Sensitivity to interest rate changes: If the prime rate goes up, so does your borrowing cost. Even a modest increase can increase your monthly payments, especially if you carry a large balance.
- Possible impact on your credit score: Using over 30% of your limit can lower your score.
- Collateral risk with secured lines of credit: The stakes are even higher if you have secured your line of credit with an asset like your home. Missing payments can result in the lender taking possession of that asset.
Knowing the potential drawbacks can help you avoid common pitfalls and make smarter financial decisions.
How Do LOCs Affect Your Credit Score?
A line of credit can boost or hurt your credit score, depending on how you manage it. When you apply for a new line of credit, your lender checks your credit report. This is known as a hard inquiry. It shows up in your credit file and may cause your score to dip slightly in the short term. While the effect is usually minor and fades within a few months, applying for several credit products in a short span can have a more noticeable negative impact.
So, it’s best to space out your applications and only use them when necessary. And keep your balance below 30% of the limit to avoid score drops. For a $10,000 line, stay under $3,000.
For Business LOCs, they typically do not affect personal credit unless you personally guarantee the loan.
Considerations About Lines of Credit for Canadians
In Canada, lines of credit come with unique rules and protections shaped by national regulations and lending practices. Awareness of these details can help you borrow more responsibly and take advantage of the safeguards built into the financial system.
- HELOC Limits: HELOCs are capped at 65% of your home value alone or 80% with a mortgage. Mortgage stress tests may limit eligibility.
- Banks must send electronic alerts when your available credit drops low, helping you avoid fees or fraud.
- You can file complaints if a lender doesn’t provide the required information.
- Line of credit insurance: Optional credit protection insurance isn’t mandatory, but review its terms carefully.
FAQs About Lines of Credit
Can I use my line of credit to pay off my credit cards?
Yes, you can use your line of credit to pay off credit cards, and this strategy often makes financial sense due to the lower interest rates typically offered on lines of credit. This approach is commonly known as debt consolidation.
When should I choose a line of credit instead of a term loan?
You should choose a line of credit instead of a term loan when you need flexible access to funds, face unpredictable expenses, or want to borrow and repay multiple times without reapplying. The decision depends largely on the nature of your financial needs.
Why might a bank reduce or cancel my line of credit?
A bank might reduce or cancel your line of credit due to changes in your creditworthiness, payment history, utilization patterns, or broader economic conditions. As a demand loan, lines of credit can be reduced or called for repayment at the bank's discretion.
Do I need to accept line of credit insurance if offered?
No, you do not need to accept line of credit insurance to be approved for your line of credit. This insurance is completely optional.
Is a line of credit reported differently on my credit report than other loans?
Yes, a line of credit is typically reported as a revolving account on your credit report, similar to credit cards but different from installment loans like mortgages or car loans. This distinction affects how it impacts your credit score and how potential lenders view your credit profile.
How much line of credit can I get?
You can have multiple lines of credit simultaneously, provided you qualify for each one based on your income, credit score, and overall debt load. Many Canadians maintain different types of lines of credit for various purposes.
What are demand line of credit products and how do they differ from standard lines?
A demand line of credit is a specialized type of credit line where the lender can call the amount borrowed due at any time, offering less borrower security but potentially more flexible terms. While most lines of credit in Canada are technically demand loans, explicit "demand LOC" products have specific features that distinguish them.
The Bottom Line
Understanding a line of credit can be a game-changer for your finances. When handled well, a line of credit gives you flexibility. But if you are not careful, it can lead to stress and debt. Following the tips in this BestMO guide, you can make smart choices and use the information to support your goals.
