What is a Line of Credit?

Line of Credit

A line of credit (LOC) is a pre-determined credit limit from which a person can draw money. For example, an individual with a $10,000 LOC would be able to borrow up to $10,000 at any point in time. However, any money they take out of this account is subtracted from the limit. The remaining balance is left to borrow. Conversely, when that individual pays back some of the principal, the remaining balance available to borrow increases by the amount they paid back. In addition, there are usually no term dates by which the money must be returned. The account user only pays interest on the amount of credit used. A LOC is similar to a credit card, except the interest rate is lower, and you can withdraw the funds as cash without extra fees (no cash advance fees).  

You can write cheques against this account, allowing you to use it for some types of purchases not possible with a credit card. The amount of interest, associated fees, and term dates are determined by the bank when the line is open, which also likely means that your credit score will impact the rate you receive. Most banks provide great flexibility when opening a line of credit, allowing the user to choose the term, payment frequency, and type of interest rate (fixed vs. variable). These choices affect the interest rate applied to the account but allow the user to determine what works best for them.

A line of credit allows an individual to spend money as they wish and provides an additional method to generate financial opportunities. In addition, a LOC can be a better alternative to credit cards and payday loans as it generally has a lower interest rate. There are many types of lines of credit: secured line of credit, unsecured line of credit, home equity line of credit, personal line of credit, and student lines of credit.  

Secured Line of Credit

A secured line of credit is when an individual puts up a personal asset as collateral against the amount they borrow. Collateral may include cars, houses, or even an investment portfolio. Individuals with a low credit score will likely be required to use a secured line of credit. Securing the loan with collateral will also decrease the interest rate on the LOC when compared to an unsecured loan. Secured LOCs have lower interest rates because the bank can seize an asset if the terms of the line of credit are not met. In other words, if the debt owed is not paid, the bank can take possession of and sell the asset used as collateral. This reduces the bank's lending risk, which reduces the interest rate.   

Pros: Security of the asset against the account allows for a lower interest rate and lower credit requirements to get the credit. 

Cons: An individual's assets can be seized if they do not make the proper payments.

Unsecured Line of Credit

An unsecured line of credit uses your financial history (credit score) and other factors such as income and education status to determine eligibility and interest rates. As this type of loan is not secured against an asset, it poses a higher risk to the bank. As a result, it has a higher interest rate than a secured loan. Examples of unsecured loans include personal lines of credit and student lines of credit. A personal line of credit can be used for debt consolidation as the interest rate is usually lower than a credit card or personal loan. A student line of credit is typically used for post-secondary education to help pay for tuition, housing, and books.

Pros: There are no assets tied to the account, allowing you to use those assets for other loans/personal finance tools.

Cons: Higher interest rate than a secured line, with higher credit and earning requirements to attain this line of credit.

Home Equity Line of Credit

A Home equity line of credit is a form of secured loan, which uses a home as collateral. Because the value for housing is so high, this type of LOC usually has the highest allowable limit and lowest associated interest rate.

Pros: Low interest rates, easy to qualify for, and high credit limit.

Cons: Requires ownership of a house and reduces your ability to loan money against that property for other uses.