Line of Credit

Line of Credit
A line of credit is a flexible loan that grants a borrower access to money (up to a specified maximum amount determined by the bank or lender). Interest is only charged on the money that the borrower chooses to use.

What is a Line of Credit?

A line of credit is a type of loan that provides a borrower access to a certain amount of money. As long as they do not exceed that maximum amount, the borrower can withdraw funds as they see fit. That maximum amount that a borrower can withdraw is called the “credit limit.” Interest is only charged on funds that the borrower withdraws.

With a typical bank loan, a borrower receives their funds in a single lump sum then pays off the principal and interest for that entire amount. But with a line of credit, the borrower is able to withdraw any amount of money up to their credit limit and will only have to repay what they actually borrowed. Additionally, interest will only accrue on funds that have been withdrawn.[1]

How does a Line of Credit work?

A line of credit (LOC) is what’s referred to as a “revolving account.” This means that you can withdraw funds within your limit, pay them off, and then withdraw them again if needed. Borrowers have the choice to pay off their balance in full or make minimum payments and maintain a balance on the line of credit.  There are some lines of credit where the available funds do not replenish as the line is paid off. These are referred to as “non-revolving accounts.”

When you get an LOC you’ll have a “draw period” and a “repayment period.” The draw period is the time during which you’re using the account and withdrawing funds as needed. This can last for up to 10 years depending on the terms set by the lender. When the draw period ends, the LOC goes into its repayment period: the time during which the total balance and interest are repaid. Additional funds cannot be accessed during repayment unless the line is renewed.[2]

What are the different types of Lines of Credit?

A majority of credit lines are unsecured loans that come in two different forms: personal or business. This means that many lines of credit won’t require you to offer up any collateral. However, there are secured lines of credit as well, like a Home Equity Line of Credit (HELOC). To get a HELOC, you’ll contact a mortgage lender or financial institution and offer up your home as collateral in order to secure the funds. In cases where the borrower still owes money on their first mortgage, the HELOC is secured by the value of your home above and beyond what is still owed on that mortgage. If you fail to make your payments on a HELOC, the lender can then seize your property to make up for their losses. A HELOC would be considered a personal line of credit.[3]

Personal lines of credit can be difficult to obtain if they’re unsecured. They’re generally only offered to those with high credit scores. The credit limit for these products is typically much higher than a normal credit card limit, and all the bank has to secure the loan is your word. A business line of credit works just like a personal LOC; the difference is that you can only use those funds for business purposes.

What are the Pros and Cons of Lines of Credit?

The appeal of a line of credit over a credit card or personal installment loan is cost: the Annual Percentage Rate (APR) for an LOC is usually much lower. They also come with higher limits, which makes the purchase of big-ticket items possible. The flexibility of an LOC is another reason people opt for these over traditional loans. Using an LOC gives you the power to choose how much money you withdraw, how often, and for what purpose.

There are many advantages to using a line of credit, but there are also disadvantages. If you choose a HELOC, you run the risk of having your home seized if you don’t make your payments. And you may not even be able to get an unsecured line of credit unless your credit score is very good. Most LOC’s come with adjustable interest rates, which means the lender can increase your interest rate and monthly payments. Make sure you know the terms of the LOC before agreeing to one.[4]

References:

  1. Fay, Bill. “Line of Credit” Debt.org. Investopedia. Accessed August 3, 2016. https://www.investopedia.com/terms/l/lineofcredit.asp

  2. “How a Line of Credit Works” Banking.com. Accessed August 3, 2016. https://banking.about.com/od/loans/p/lineofcredit.htm

  3. Barrymore, John “How Lines of Credit Work” HowStuffWorks Money. Accessed August 3, 2016. https://money.howstuffworks.com/personal-finance/banking/lines-of-credit.htm

  4. Warden, Peter “Pros and Cons of a Personal Line of Credit” LendingTree. August 11, 2015. https://www.lendingtree.com/personal-loan/pros-and-cons-of-a-personal-line-of-credit-article