Borrowing 101: Introduction to Loans and Lines of Credit
Apr 27, 2020 • 5 min read
With all the different credit options available in Canada, it’s important to understand the differences between each one so that you can find the right product for your needs. Credit can be useful to help you establish a history and finance purchases, but should be used mindfully.
In this Borrowing 101 article, we’ll give you an overview of personal loans and lines of credit to help you understand how they work, when to use them, and what to be careful of in order to protect your credit score.
How do Personal Loans Work?
Personal loans are a fixed amount of money that you borrow and pay back with interest in monthly instalments over a predetermined time period. Interest is charged on the full amount of the loan as soon as you take it out, regardless of when you end up using the money. Once your loan is paid off in full, your account is closed. If you needed to access more money you’d have to apply for another loan.
Personal loans can be secured or unsecured. Secured loans are backed by collateral, meaning something you own, like a car. If you’re unable to make the payment amount on your loan the lender typically has the right to claim your asset, such as your car. Unsecured loans aren’t backed by collateral. Lenders will decide whether you qualify based on your financial history, so checking your credit before you apply will let you know if you need to take steps to improve it in order to access a better range of offers.
These loans can have both fixed or variable interest rates and loan terms vary between 6 and 60 months.
When are Personal Loans Useful?
Personal loans can be used to consolidate debt, pay off a credit card, finance a major purchase such as a car or home improvement project, or finance a small business. If you want to apply for a personal loan it is helpful to know exactly how much money you need, what you need it for, and if you’ll be able to meet the monthly repayments.
Personal loans, like a line of credit, can be a useful way to consolidate high-interest consumer debt such as credit card debt. By consolidating your debt you’ll only have one monthly payment with a lower interest rate, which could help you save money and pay back your debt sooner.
What to be Careful of
With a personal loan, you get a lump sum of money and start paying interest immediately, regardless of when you spend the money. Unsecured personal loans can have higher interest rates than secured loans, including home equity lines of credit (we’ll discuss lines of credit in the next section). There can be prepayment penalties for paying your loan off in full before your loan term is up so be sure to carefully review the terms.
As with any type of credit, it’s important to think about why you need the money and ensure you have space in your budget to make and pay your bills on time.
How do Lines of Credit Work?
A line of credit is a fixed amount of money, called your credit limit, that you’re able to access as you need and pay back with interest. Interest isn’t charged until you actually borrow money and you’ll only be charged monthly minimum payments during the months when you’ve borrowed. You can pay back as little as the minimum payment or as much as you want. There are no penalties for paying off the balance in full.
A line of credit is considered revolving, meaning that once you pay back the money you have access to that amount of credit again. Let’s say that your bank gives you a line of credit with a limit of $10,000. If you take out $2,000 one month and pay back $2,000 the following month, you once again have access to $10,000. Similar to a credit card, a line of credit gives you access to money “on-demand”. You apply once and use available credit when you need it.
Personal lines of credit are typically unsecured loans, meaning you don’t need to use collateral, such as a house or car, to get them. Most have variable interest rates and the terms are often more flexible than a personal loan.
When are Lines of Credit Useful?
A secured or unsecured line of credit can be used to consolidate debt and finance home projects, education costs, or other ongoing major expenses. It can also be useful for a big project, like a home renovation, where costs are difficult to estimate and can shift over time. A line of credit can give you more buffer and flexibility than a personal loan would because you can continue to use the loan over and over, as long as you pay back the money.
Just like a personal loan, a line of credit can be a good way to consolidate high-interest consumer debts into one payment with a lower interest rate.
What to be Careful of
Because a line of credit is more flexible than a personal loan you have to be extremely diligent about how you use it. Just because you have access to the money doesn’t mean you should take advantage of it. Like with a credit card, it could be tempting to only make the minimum payments but that will cost you more in interest over the long run.
If you’re looking at a line of credit as a way to avoid defaulting on another loan, it’s best to address what’s causing that existing financial strain, make a budget, and put a plan in place to pay back your debt while re-establishing good credit in the eyes of the credit bureaus.
You’ll also want to be mindful of the terms of the loan, how the variable rate is changing over time, and any fees it may have such as an annual fee.
The Bottom Line
Before applying for any type of loan check your Equifax credit report free from Borrowell and see if there is anything you can do to improve your financial health. Increasing your score can mean more attractive interest rates and offers on things like credit cards, loans, mortgages and lines of credit. Sign up or Log in to quickly see which products match your profile and your likelihood of approval.
Used wisely, credit can be a wonderful tool to help you achieve your lifestyle and financial goals. Always make a plan for how you’ll use the money and how you’ll pay it back.
Borrowell is dedicated to making financial stability possible for everyone. With over 1.5 million members, the company offers free credit scores in Canada, education, weekly credit monitoring, credit building solutions, as well as digital tools like AI-powered credit coaching and personalized financial product recommendations. For more information, visit borrowell.com or download the mobile app for Android or iOS.