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Line of Credit: Protecting Yourself from a Financial Emergency

By Debt.ca on May 14, 2014 No Comments

Most people don’t get into debt on purpose; they get into debt because they run into financial difficulty. While some people are in debt because they aren’t able to get their spending under control, others are in debt because they run into a financial emergency, such as job loss, illness, or an unexpected major expense. While it’s typically recommended you should have an emergency fund – between three to six months’ living expenses earmarked for a rainy day – not everyone can afford that. The next best thing can be to set up a line of credit.

What is a Line of Credit?

A line of credit is ideal if you’re running into a temporary financial bind. For example, if your car breaks down and you need a new car right away to get to work, a line of credit can help bridge the gap. A line of credit is a temporary loan your bank will allow you to take to cover short-term financial shortfalls. Lenders typically provide them to people with good credit ratings and a decent annual salary. Generally, the higher your credit score, the higher your approval limit.

Similar to variable rate mortgages, the interest rates on lines of credit are based on the prime rate plus a spread. For example, today you can get a line of credit for as little as prime plus 50 basis points. The best part about a line of credit is that it’s there when you need it; you don’t pay any interest or an annual fee unless you use it. The minimum payment isn’t too burdensome; the minimum monthly payments are typically 3 per cent of your outstanding balance plus interest.

Using a Line of Credit Wisely

Similar to a credit card, a line of credit should be used for emergencies only. You can quickly find yourself in a debt trap if you use it to finance purchases you can’t afford today like a new big screen TV or stereo system. The best part about lines of credit is that they almost always come with a lower interest rate than credit cards.

If you’re carrying a balance on your credit card, a good way to save on interest is to pay off your outstanding balance with your line of credit; just be sure to develop a realistic repayment plan. If you’re saving up for a down payment for a house, using your line of credit is a bad idea; it will hurt your borrowing ratio and you’ll end up qualifying for a lower mortgage amount.

Secured vs. Unsecured Lines of Credit

There are two main types of lines of credit. As the name suggests, unsecured lines of credit aren’t backed by any asset, so not surprisingly they carry the highest rate of interest. Meanwhile, secured lines of credits are backed by a valuable asset like your family home or investments. It’s almost always better to go with a secured line of credit when possible, as you can end up saving a lot on interest.

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