At some point in your life you will need to borrow money. It could be for buying a car or making a major repair to your house. When that time comes it’s good to know the difference between loans and a line of credit.
Loans
Loans are where you borrow a fixed amount of money and then start making monthly payments to pay back the loan. If you have a loan for $20,000 you would start paying back the loan monthly with interest. This is typically how a car loan is structured.
Usually, a fixed interest rate is applied to a loan. A fixed interest rate tracks government bond yields but at a 1% to 2% increase. For example, when government bond yields are 2%, banks would offer a 3% to 4% fixed interest rate. The spread between the government bond yields and the big bank fixed interest rate vary by bank. Big banks such as CIBC, TD, Scotiabank, RBC, and the Bank of Montreal will adjust their rates to be less or more competitive. If a bank wants more business they set their fixed interest rate closer to the government bond yield to offer a lower fixed rate. If they want less business then they raise their fixed interest rates farther from the government bond yield to offer a higher fixed rate.
Line of Credit
A line of credit is where you borrow some money and only pay interest on the money that you borrow. If you have a $20,000 line of credit and you use $10,000 then you only pay interest on the $10,000. To pay back the $10,000 you would have to pay more than the interest each month.
Usually, a variable interest rate is applied to a line of credit. A variable interest rate is the prime rate that banks offer, plus or minus a percentage interest. The prime rate changes based on the Bank of Canada’s decision to raise or lower the benchmark rate. Visit the Bank of Canada’s interest rate policy page for more information on the benchmark rate.
Variable Interest Rate
The variable interest rate is determined by the Bank of Canada’s benchmark rate and the big banks such as CIBC, TD, Scotiabank, RBC, and the Bank of Montreal. For example, if the Bank of Canada sets the benchmark rate at 3% then the big banks usually set their prime rate about 2% higher. The prime rate would be 3% + 2% = 5%. Then, the big banks add different amounts of percentage interest based on a variety of factors such as your credit score, payment history, and bank programs. For this example, the big bank decides to add 3% to the 5% prime rate making a 8% variable interest rate. It is very important to determine the interest rate your paying on borrowed money to ensure you can afford the payments.
Your variable interest rate can change while you have borrowed money on your line of credit. The amount you pay in interest can increase or decrease based on the Bank of Canada changing the benchmark rate and not just based on the amount you borrow.
Variable Interest Rate Calculation
For example, you borrow $10,000 at 8% (based on the calculation above) so you have to pay $10,000 x 0.08 = $800 of interest a year or $800/ 12 = $66.67 of interest a month. Then, the Bank of Canada raises the bench mark rate by 0.5% to 3.5%. The bank prime rate would now be 3.5% + 2% = 5.5% and then the big bank adds an extra 3% percentage interest so your variable interest rate is now 8.5% on your line of credit. Now, you have to pay $10,000 x 0.085 = $850 of interest a year or $850/ 12 = $70.83 of interest a month. You need to be aware of the possibility of these changes happening to you and changing your payment amount. It’s especially important if your borrowing a large amount of money causing the monthly payments to increase more significantly.
Secured or Unsecured
A loan or a line of credit can be secured or unsecured depending on your preference or eligibility. If secured, it would be against an asset that you own, typically a house. The benefit of a secured product is that it usually has a lower interest rate than a unsecured product.
Should you use a loan or a line of credit?
This question is dependent on a variety of factors and if you know the difference between loans and a line of credit will help you determine what borrowing product will suit your needs.
If you’re going to use all the money right away and are confident you can afford the monthly payment to pay back the loan, plus interest, then a loan is the right choice for you.
If you’re only going to use some of the money and are confident you can make the monthly interest payments and have the discipline to pay back the line of credit, then a line of credit is the right choice for you. It’s important to be aware that making the monthly interest payment will not pay back the line of credit.
On a loan your monthly payment is a combination of principal and interest and on a line of credit your monthly payment is interest only. Therefore, your monthly payments on a line of credit would be less then on a loan. However, to pay back the line of credit you would have to pay more than the interest payment each month. The principal amount of a loan payment goes towards paying back the actual loan so no additional payments are necessary. You would only make additional payments to a loan if you want to pay it back faster.
Loans and a Line of Credit Payment Comparison
When determining your monthly payment, it’s important to know the difference between loans and a line of credit in regard to interest rates and payment structure.
A loan of $10,000 at 5% interest over 5 years:
You would pay $106.07 every month for 5 years making the total amount paid $12,727.86.
Therefore, to borrow $10,000 you would have to pay $2,727.86 in interest.
A line of credit of $10,000 at 5%:
If you used the full $10,000 then you would pay $41.67 of interest a month. Don’t forget that none of this money goes towards the $10,000 you borrowed.
Based on the examples above, the loan is paid off in 5 years and there is still $10,000 to be paid back on the line of credit.
Conclusion
In conclusion, a line of credit offers more flexibility than a loan. You can choose how much you borrow, when you use it, and pay a lower monthly payment. However, you have to make additional monthly payments to pay back the line of credit. A loan ensures you put money towards the principal and interest each month. Also, your payments stay the same throughout the term of the loan because of the fixed interest rate. Now that you know the difference between loans and a line of credit, you can make more informed decisions when borrowing money.
| This blog is for general information and educational purposes only and is not financial advice nor should it be substituted as professional advice. Before taking any financial action based upon any information, you should consult with the appropriate professionals. THE USE OR RELIANCE OF ANY INFORMATION CONTAINED ON THIS SITE IS SOLELY AT YOUR OWN RISK. |
