Line of credit

A line of credit (LOC) is an account type that allows borrowing up to a pre-set limit.^[1] You have the flexibility to use as little or as much of the funds, up to a specified maximum. There is typically no payment schedule and you only have to pay interest on the borrowed funds.

There may be a fee required when setting up a line of credit. A line of credit can be either secured or unsecured.

A secured line of credit is usually secured by equity in your home, and is known as a home equity line of credit (HELOC).^[1]

The unsecured type carries a higher interest rate. These include personal lines of credit and student LOCs.^[1]

This article first discusses practical aspects, such as how to apply for a line of credit or how to use it. It then lists the pros and cons of this product. The potential dark side of lines of credits, and HELOCs in particular, is explored. The question of whether lines of credits are suitable substitutes for emergency funds is finally addressed.

Applying for a line of credit

You can't automatically get a line of credit as it's equivalent to borrowing money. You have to apply at your financial institution. You need to decide for which type you qualify.

If you have paid off some of your mortgage you may get a secured line of credit. This is only possible if you have enough equity in your home. You can usually borrow 65% of your total equity up to a maximum of 80% if taken at the same time as your mortgage^[2]. This option will offer a lower interest rate.

If you have a good credit history and means to repay the line of credit, you will qualify for a personal line of credit. The lender will usually want to verify your income.

Using your line of credit account

A LOC account functions like a normal bank account except the balance is usually negative. There are options to write cheques and use a bank card on these types of account. Of course, you have to pay interest on any outstanding negative balances.

You must repay the interest every month. With some institutions and in the case of unsecured lines of credit, you must also repay some minimum percentage of the outstanding balance, usually around 3%.

Advantages and disadvantages

Pros

The interest rate is lower than for a credit card or personal loan, especially for a secured LOC^[1]
According to the Financial Consumer Agency of Canada, using a mix of credit products (such as a credit card, a mortgage and a line of credit) can improve your credit score.^[3]
An unused line of credit costs nothing, but improves your credit usage rate (actual amount borrowed divided by total credit available). The FCAC recommends that consumers use less than 35% of their available credit.^[3]

Cons

With a line of credit, you may only have to pay the interest, with no imposed schedule to reimburse the capital. It may be tempting to borrow more and more.
The interest rate is typically variable. If interest rates rise, it may be more difficult to make payments and reimburse the loan.^[1]
The lender can reduce the credit limit at any time and even demand that the full amount be repaid^[2]
If the minimum payments are not made, your credit score will suffer^[2]
For HELOCs, "your lender can take possession of your home if you miss payments"^[2]

Welcome to the dark side

In a survey published in 2018, the Financial Consumer Agency of Canada (FCAC) found that 19% of respondents were using a HELOC for day-to-day expenses.^[4] Further, 29% of all respondents used their HELOCs to meet payments on other credit products "sometimes, frequently or most or all of the time". This figure rose to 63% in the 25-34 years-old age group. And within this age group, 46% of HELOC borrowers "said they would struggle if their payment increased by $99 a month".^[4]

Lines of credit can create lifestyle inflation^[5], can cause a lot of stress, and can be difficult to repay. They may also lead to a spiral of "home equity extraction debt, particularly during periods of financial distress".^[5]

Rob Carrick asked financial planner Shannon Lee Simmons "Of all the types of borrowing you see your clients using, what is the one that causes the most damage?" and here was her answer:^[6]

I would say lines of credit. Credit cards get a lot of hate because they’re very high interest, and I do think they’re a problem. But where I see the really crushing debt is often on lines of credit.

Line of credit versus emergency fund

Some Canadians think of lines of credit, including HELOCs, as equivalent to an emergency fund, and 14% of FCAC survey respondents actually use it that way.^[4] Some lenders market HELOCs "as a way to manage temporary income shortfalls or unanticipated expenses".^[5] After all, the thinking goes, why park cash at very low interest rates in a savings account when you can invest it or spend it, and instead rely on a line of credit for emergencies? The problem is that unlike cash in a savings account, the line of credit may not be there when you need it.

To an extent that will surprise a lot of HELOC holders, banks and other lenders have almost unlimited power to change the terms of these popular borrowing vehicles.^[7]

For example, the credit limit could be lowered, a HELOC could be converted to a regular mortgage (with payments made up of a blend of interest and principal), or in extreme cases, the loan could be recalled, forcing you to repay everything.^[7]

In the FCAC survey, only 39% of HELOC holders actually knew that "your lender can require you to repay your HELOC at any time", and only 15% knew that "a financial institution can increase a HELOC’s interest rate at its discretion".^[4]

References

^ ^a ^b ^c ^d ^e Financial Consumer Agency of Canada, Lines of credit, viewed October 21, 2021.
^ ^a ^b ^c ^d Financial Consumer Agency of Canada, Getting a home equity line of credit, viewed January 10, 2021.
^ ^a ^b Financial Consumer Agency of Canada, Improving your credit score, viewed January 10, 2021.
^ ^a ^b ^c ^d Financial Consumer Agency of Canada, Home equity lines of credit: Consumer knowledge and behaviour, ISBN 978-0-660-29009-6, viewed January 11, 2021.
^ ^a ^b ^c Financial Consumer Agency of Canada (FCAC), Home equity lines of credit: Market trends and consumer issues, 2017, ISBN 978-0-660-08671-2, viewed January 12, 2021.
^ Rob Carrick, Credit cards get the hate, but HELOCs are the crushing debt, The Globe and Mail, January 17, 2019, viewed January 12, 2021.
^ ^a ^b Rob Carrick, In tough times, banks can take your HELOC safety net away, The Globe and Mail, April 8, 2020, viewed January 12, 2021.

External links

Ellen Roseman (March 2, 2020). "Ellen Roseman: Interest-only HELOC payments come with risks". LowestRates.ca.
Kelsey Rolfe (February 8, 2023). "HELOCs 101: What is a home equity line of credit?". The Globe and Mail.

[FCAC-LOC-1] Financial Consumer Agency of Canada, Lines of credit, viewed October 21, 2021.

[FCAC-HELOC-2] Financial Consumer Agency of Canada, Getting a home equity line of credit, viewed January 10, 2021.

[FCAC-score-3] Financial Consumer Agency of Canada, Improving your credit score, viewed January 10, 2021.

[FCAC-survey-4] Financial Consumer Agency of Canada, Home equity lines of credit: Consumer knowledge and behaviour, ISBN 978-0-660-29009-6, viewed January 11, 2021.

[FCAC-trends-5] Financial Consumer Agency of Canada (FCAC), Home equity lines of credit: Market trends and consumer issues, 2017, ISBN 978-0-660-08671-2, viewed January 12, 2021.

[Carrick-crushing-6] Rob Carrick, Credit cards get the hate, but HELOCs are the crushing debt, The Globe and Mail, January 17, 2019, viewed January 12, 2021.

[Carrick-tough-7] Rob Carrick, In tough times, banks can take your HELOC safety net away, The Globe and Mail, April 8, 2020, viewed January 12, 2021.

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