A line of credit constitutes an arrangement between a potential borrower and a financial institute like a bank or credit union. This arrangement allows the borrower access to a specified sum of money, which they can utilize as needed. The unique aspect of this financial tool is that the interest is only levied on the amount borrowed, not the entire credit line.
Understanding Lines of Credit
A line of credit is a flexible financial instrument that can assist with various expenditures such as home improvements or sudden vehicle repairs. If you qualify, you can draw on the line of credit up to a established limit for a specific period.
You’re only required to pay interest when you borrow from the line of credit. Once you repay the borrowed amount, it becomes available to borrow again. This financial tool’s flexibility enables you to decide when to withdraw money, repay it, and repeat the process—provided you adhere to the terms, including repaying what you borrow on time and in full.
Working Mechanism of Lines of Credit
When you require funds, you generally have two options—apply for a loan or a line of credit. With a loan, you receive a lump sum of money and start paying interest immediately, irrespective of when you utilize the funds.
On the other hand, a line of credit provides you with a set amount of money that you can borrow as needed. Interest is not charged until you actually borrow.
There are business lines of credit, but in this article, we focus on personal lines of credit.
Unsecured Lines of Credit
Personal lines of credit are typically unsecured, meaning you don’t need to pledge any collateral to avail the credit line. However, secured lines of credit require collateral, such as your home or a savings account.
When applying for a line of credit, having better credit scores can help you secure a lower annual percentage rate. Some lines of credit may come with fees, such as an annual fee, and limits on the amount you can borrow.
Draw Period and Repayment Period
Once you qualify for a line of credit, there’s a set time frame—known as the “draw period”—when you can withdraw money. Draw periods can last several years, and the bank may provide special checks, a card, or transfer the money to your checking account when you’re ready to borrow.
When you borrow money from your line of credit, interest typically starts accruing, and you must start making at least minimum payments. These payments are added back to your available line of credit. However, once the draw period ends, you enter the repayment period where you have a set time to repay any remaining balance. Bear in mind, only making minimum payments may result in higher interest costs in the long term.
Impact on Credit Scores
The application process for a line of credit may involve a hard inquiry on your credit reports, which could temporarily lower your credit scores by a few points. After approval and acceptance, it usually appears on your credit reports as a new account.
If you barely use your available credit or use only a small percentage, it might lower your credit utilization rate and improve your credit scores. However, borrowing a high percentage of the line could increase your utilization rate and potentially harm your credit scores. Late payments can also negatively affect your credit health.
Secured Lines of Credit
A secured line of credit is an option if you wish to borrow against a collateral like your home equity or a certificate of deposit. One popular type of secured line of credit is a Home Equity Line of Credit (HELOC).
A HELOC allows you to borrow against the available equity in your home, using your home as collateral. They typically come with a variable interest rate, which means your payments may increase over time. Banks usually limit the amount you can borrow to up to 85% of your home’s appraised value, minus the remaining balance on your mortgage. Your credit history, income, and other factors come into play when determining your interest rate.
The downside of a secured line of credit is that if you can’t make the payments, the lender may seize the asset that secured the line.
Unsecured Lines of Credit
With an unsecured line of credit, you don’t risk losing your home or savings if you default. However, the lender assumes more risk with unsecured loans, which could result in higher interest rates compared to a secured line.
The terms of every unsecured line of credit are unique. The limits may range from a few thousand to a few hundred thousand dollars. Some lines of credit come with fees—for instance, you might have to pay an annual fee to keep the account open.
Lines of Credit vs. Credit Cards
Credit cards are similar to lines of credit in that they are both revolving lines of credit. You can borrow up to the credit limit, repay it (plus any interest owed), and borrow it again.
However, there are key differences between the two. For instance, credit cards don’t have a draw period—you can use the card as long as the account is open and in good standing. Many come with rewards programs, and if you pay off your balance on time and in full each month (if your card has a grace period), you may avoid paying interest altogether. This makes credit cards potentially better for everyday spending, if used responsibly.
The downside to credit cards is they may come with higher interest rates than lines of credit, so maintaining a balance on one may cost you more. They may also offer lower limits than personal lines of credit, and you could face high fees and APRs if you want to take out cash with a cash advance from a credit card.
Best Practices for Using a Line of Credit
Before applying for a line of credit—secured or unsecured—check your credit scores and take steps to improve your credit health. This could enhance your chances of qualifying for a lower interest rate. Then, determine how much you need and how you plan to use the funds.
If you need a flexible way to access funds, a line of credit may be a good idea. However, if you’re borrowing to avoid financial trouble with another loan, there might be deeper issues that need resolving, which can’t be addressed by continuing a cycle of borrowing.
When to Avoid Using a Line of Credit
If your income is unstable or you can’t afford the repayments, a line of credit might not be a good choice. Defaulting on payments can severely damage your credit. Plus, on a secured line of credit, the lender may seize the collateral.
If you know precisely how much you need and you don’t want to use collateral, an unsecured personal loan with better rates than an unsecured line of credit might be a better choice, depending on your credit.
If you’re using the line of credit for basic needs or to fund short-term expenses like dining out and vacations, that might be a red flag that you’re struggling financially and should avoid taking out new debt.
When to Use a Line of Credit
If you need money for a significant expense like a home improvement project, education costs, or other types, a HELOC or secured line of credit may be a good idea—as long as you know you’ll have the money for repayment. Bonus: The interest you pay on the HELOC may be tax-deductible.
An unsecured personal line of credit may help you consolidate several small debts into one payment with a lower APR, while avoiding using collateral (depending on the terms of each line of credit and your creditworthiness).
Conclusion
Understanding the Things You Need to Know About Lines of Credit is crucial before deciding to apply for one. Whether it’s secured or unsecured, a line of credit provides financial flexibility. However, it must be used responsibly, as misuse can lead to debt and negative impacts on your credit scores. Understanding the terms, repayment structure, and potential impacts on your credit can help you make an informed decision.
