How does a line of credit work? Make sense
#MakeItMakeSense is a series from The Star that breaks down personal finance matters to help young Canadians gain more confidence and understanding when it comes to financial literacy.
No matter what financial institution you deal with, you’ve probably been tempted to open a line of credit at some point, but as tempting as it may be to access more credit, is that all does the world need it? And in what situations can it benefit someone?
Money expert Jessica Moorhouse says not everyone needs a line of credit, but if people do use it, it’s important to have a plan because, she says, they’re “known for keep people in a cycle of indebtedness”.
“Like any type of credit, it’s only useful if you know you can repay it. And too often people just get a line of credit because they think they’re supposed to,” she said, pointing out that most people end up with difficult debt and interest rates. high interest or don’t use their line of credit after setting it up.
So when can lines of credit be a good option for Canadians, and what should people be aware of? We tapped Moorhouse to break it down in this week’s #MakeItMakeSense.
What is a line of credit and what is it used for?
A line of credit, similar to a credit card, is a type of loan that lets you borrow money up to a set limit. You can use as few or as many funds as you want, as long as they don’t exceed this limit.
“(The criteria) are based on things like your income, the amount of debt you have with other financial institutions, your credit score and your creditworthiness,” she said, adding that it depends on reliability. from your borrower.
Lines of credit can be secured or unsecured. An example of a secured line of credit is the home equity line of credit, where the borrower’s home is used as collateral in order to obtain the line of credit. In the case of secured lines of credit, if borrowers are unable to repay what they owe, lenders can take possession of the asset they have pledged.
Unsecured lines of credit, such as a personal line or a student line, can be obtained without having to post collateral assets.
A student line of credit is often used to pay for post-secondary education costs, such as tuition or living expenses, while a personal line of credit can be used for any large or unexpected expense such as home renovations. or auto repairs, Moorhouse explained.
How do interest rates compare to other forms of credit?
Most lines of credit offer lower interest rates than credit cards, which generally attracts people, Moorhouse said.
You only pay interest on the money you borrow, but unlike a credit card which usually has a grace period until your bill is due, on a line of credit the interest will accrue to from the day you borrow the money until the day you pay it back. .
She notes, however, that lines of credit tend to offer variable interest rates while most credit cards offer a fixed rate. This can be tricky because if a line of credit is variable, as interest rates rise and fall, your interest rate on that line of credit will also rise, Moorhouse explained.
“I wouldn’t want to be stuck in a situation where I had a big, heavy line of credit at a time when interest rates have gone up and keep going up…It makes repayment much more expensive. everything you borrowed,” she said.
“Keep that in mind, especially right now…because the interest rate you’re paying on that line of credit today, we’re not done raising interest rates, it’s going to be higher in the future,” Moorhouse said.
How do line of credit repayments work?
Just like a credit card, there’s always a monthly minimum payment to meet if you can’t pay the balance in full. If you are unable to pay it, lenders can potentially take possession of the assets you have pledged or you will have to pay additional fees. Not paying can also hurt your credit score, she adds.
While lines of credit tend to offer lower interest rates than credit cards or other types of loans, Moorhouse stresses the importance of always having a plan for paying it back.
Moorhouse notes that lines of credit are also commonly used for debt consolidation – that is, when a person has many different debts, from credit cards to car loans, and finds themselves in a difficult situation where their debt increases due to accrued interest.
“What they’re doing is wrapping them all up in one debt under a line of credit. So this lender will pay off all these debts… and then you just have to pay a loan… And the idea is, well, if I can consolidate all these debts, and they’re all at a lower interest rate than what the average was, then (you) save money and interest,” she said.
But, Moorhouse said, many people often have no intention of paying back and continue to borrow with other credit cards, ending up in another cycle of debt.
“(Lines of credit) can be great tools if you use them responsibly, but most people don’t because of a lack of financial knowledge, bad advice, industry and all. just don’t plan, use them with caution,” she said.
When might a line of credit be a good option to consider?
A line of credit can be great if you need another way to make big purchases or can’t get another type of loan, Moorhouse said.
Let’s say you want to buy a car but you don’t want to go through the car dealership or you don’t have the funds right now but you know you will in the near future, that’s where a line of credit can be a good alternative in ordering for you to make that purchase, she says.
“But again, you need to have a reason why you’re borrowing this money and a plan to pay it back and pay it back as soon as you can,” she said.
Additionally, Moorhouse points to someone she knew in college who didn’t qualify for a government student loan and had to turn to a student line of credit instead to help pay her tuition fees. schooling.
“Generally, student lines of credit have lower interest rates because they’re for a specific purpose like tuition and books,” Moorhouse said.
If people are interested in getting a line of credit, Moorhouse stresses the importance of understanding what you’re getting into before setting it up.
“Ask what your obligations are, what are the minimum payments, are there annual administration or setup fees? It’s good to know what kinds of other fees may also be involved,” she said.
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