A question came up in conversation recently about the difference between overdraft and a line of credit. If you’re not sure, I hope this is helpful.
Overdraft protection covers you if you have too much money coming out of your account. Say too many bills go through all at once and your account dips below zero. The overdraft will cover you until you can top it back up. That way no cheques bounce and you save the non-sufficient funds charges (and all that hassle!). Sometimes banks charge fees, interest or both. You have to set it up with your bank first though, it’s not automatic.
A line of credit is borrowing money from a pre-authorized credit account. It’s like a credit card that is just there like a bank account. You can dip into it when you need to. Usually it has good interest rates (low), like prime plus one.
What’s prime all about? The prime rate is set by the Bank of Canada. Banks have money flowing in and out just like your account does, and to tide them over until their thousands of accounts settle every day, the Bank of Canada loans them money at a set interest rate — the prime rate. Banks usually use that rate as a guideline and add extra to it when they loan out money — that extra is profit.
What rate you get depends on your bank, your negotiating skills and your credit rating (or credit score). Every time you use credit, you’re building your rating – the information gets filed automatically. If you’re renting an apartment, arranging a mortgage on a house or applying for a credit card, all those companies are going to check your credit rating to see if they can trust that you’re going to pay them on time.
It’s a good idea to check your rating every now and then, because mistakes can cost you. Check it for free at Equifax or TransUnion. A bad credit score means you’re going to pay more interest, because the company loaning you money is taking a chance on you and they want to be compensated to make it worth their while.
Talk to your bank about what they offer and how overdraft or a line of credit would work for you. Of course, if you have issues with overspending you might need one (overdraft) more than the other (another credit source!).
Don’t let the bank talk you into more credit than you need either. That’s like getting the meal deal for only a little bit more, which is tempting, but you know the fries and cola aren’t good for you.
(Note to self for future blog topic — how a budget is like a diet.)
So there you have it, some basic definitions of a couple common financial tools. If you have any suggestions for other explanations you’d like to see, please let me know in the comments.