A line of credit is a popular type of loan in Canada. It’s crucial to have a full understanding of how this form of credit works because how you manage it will directly affect your credit score. If you manage your line of credit wisely, it can increase your score. On the other hand, if you often miss payments and don’t use it responsibly, a line of credit can have a significant negative impact on your credit score and your overall credit report.
A line of credit affects your credit score because how you use it will impact several key factors that credit bureaus use to measure your financial health. The five main factors that credit bureaus rely on to get your score are:
Payment history (35%)
Credit utilization (30%)
Credit history (15%)
Credit mix (10%)
Credit inquiries/credit checks (10%)
The biggest factor, payment history, is your track record of making payments on time (or not). So, if you often miss payments on your line of credit, your score will decrease quite a bit over time because payment history is such a major part of your overall score.
How A Line Of Credit Works
To understand why a personal line of credit can influence your credit score, it’s helpful to briefly review how a line of credit works.
When you take out personal lines of credit from a bank or alternative financial institution, you can borrow money up to a pre-set limit and you’re not required to use the funds for a specific purpose (though they are often used for things like home renos or a vacation). Interest rates on personal lines of credit are variable, meaning that they can go up or down depending on the lender’s prime rate.
Does a Personal Line of Credit Hurt Your Credit Score?
There is no simple answer to the question “does a personal line of credit hurt your credit score.” That’s because the good or bad influence it will have on your score is entirely dependent on how you manage your credit. A personal line of credit could hurt your score if you:
Make late payments. Payment history is the single biggest factor affecting your score so too many missed payments will eventually sink your score.
Use too much credit. Credit utilization is the amount of credit you’re currently using out of the total credit available to you. If you’re using more than 30% of your total available credit, your score will take a hit.
Hard credit check. When you first apply for a line of credit, your application could result in a “hard pull” on your credit file, temporarily lowering your score.
Will a Personal Line of Credit Increase My Credit Score?
Whether or not obtaining a personal line of credit increases your credit score is contingent on whether you handle the credit account responsibly. Personal lines of credit could increase your score if:
You never miss a payment. Payment history has the biggest impact on your score, so ensuring you always pay your balance in full and on time will keep your score on an upward trajectory.
You are aware of your overall credit utilization ratio. Add up all your credit accounts and aim to stay under 30% of your available credit. Take out only the funds you need.
What Are The Benefits of Obtaining a Personal Line of Credit?
There are some significant benefits to obtaining a personal line of credit.
Improving Your Credit Utilization Rate
The more money you have access to, the better chance you have of maintaining a low credit utilization ratio.
Improving Your Payment History
As long as you are vigilant about always making the required payments, a line of credit can give your score a big boost.
Improving Your Credit Mix
It’s possible that having different types of credit (such as revolving and installment credit, see below for details about these types of credit) accounts on your credit file can give your score a bit of a boost. Getting a line of credit would be a good way to include revolving credit in your credit report.
What Are The Disadvantages of a Personal Line of Credit?
There are some potential disadvantages to getting a personal line of credit.
Hurting Your Credit Utilization Rate
Taking out too much money from your line of credit could result in a higher credit utilization rate, especially if you’re carrying large balances on other credit products like credit cards.
Hurting Your Payment History
If you miss even just one payment, your credit score will start to slip.
Hurting Your Credit History
While it will positively affect your credit score in the long run, initially a new line of credit will decrease the overall average age of your accounts and thus potentially decrease your score.
Hard Credit Check
When you apply for a line of credit, it could result in a hard credit inquiry on your credit report which would temporarily decrease your score.
Is a Personal Loan Better Than a Personal Line of Credit?
To understand whether a personal loan is better than a personal line of credit, it helps to compare these two types of loans.
In general, there are two main kinds of credit: revolving and installment. Things like personal lines of credit and credit cards are categorized as revolving credit because you can keep borrowing different amounts of money (up to your credit limit) and then pay back the money on an ongoing basis. As long as your account is in good standing, you can continue to use revolving credit indefinitely.
Installment credit like a personal loan, however, is paid back to your lender through regular scheduled payments over a set period of time at a pre-established rate of interest. The payment amount usually stays the same over the course of the loan. Unlike with a line of credit, borrowers can’t take out more money or make payments whenever they want to. When the funds are repaid, the loan is closed. Examples of installment loans are vehicle loans, mortgages and personal loans.
Both revolving and installment loans can affect your credit score, however revolving loans like lines of credit have a more powerful influence over your score. That’s because while both types of loans impact credit score factors like payment history, credit inquiries and credit history, only revolving credit impacts credit utilization. Because credit utilization makes up such a big part of your score, revolving forms of credit like a line of credit will have a larger influence on your credit score than a personal loan.
Other things to consider when deciding whether a personal loan or line of credit is right for you:
Interest rates: Go with a personal loan if you want a stable interest rate. Interest rates with lines of credit tend to be variable whereas personal loan rates are fixed and are thus better for those who prefer certainty. That being said, interest rates with lines of credit tend to be lower than personal loan rates.
Flexibility: With a personal loan, you must take one lump sum, but with a line of credit you can take out as little or as much as you want up to your credit limit.
Overspending: Personal lines of credit can lead to debt if you aren’t disciplined about only taking out what you need and paying back funds in a timely manner.
What Happens if I Don’t Use My Personal Line of Credit?
If you don’t use your line of credit and the account sits dormant for a long period of time, your bank may close your account. This could cause your score to decrease because the loss of the account would shrink your available credit (and thus negatively affect your credit utilization). Having your account closed might also potentially shorten your credit history if your line of credit was one of the first credit accounts you opened.
Try to keep a personal line of credit account active even if it means only using it once a year. You may also want to reach out to your bank to ask what you can do to ensure they don’t close your account.
The Bottom Line
A personal line of credit can have a significant impact on your credit score. However, whether or not a line of credit increases or decreases your score will depend entirely on how you manage your account. The key to getting and keeping a good credit score is to ensure you make timely payments and don’t borrow so much that it negatively affects your credit utilization
