What’s a line of credit and is it right for you?
A line of credit offers quick access to cash, but it can come at a cost.
Contributing Writer at Tally
April 9, 2020
There’s no shortage of ways to get your hands on the cash you need to get through a temporary hardship, a big home repair project or another pricey life event. Standard loans are relatively simple to understand, but a line of credit can cause some consumers and business owners to pause and wonder if it’s the right option.
In this article, we explain what a credit line is, the three main credit line types and when you might want to use one.
What is a line of credit?
A credit line is similar to a credit card in that it’s an on-demand source of funds you can dip into as needed. Like a credit card, you only pay interest on the amount of credit you use. If you max it out, you can’t use it again until you pay down the balance. Accessing funds is convenient, as the lender will issue you checks, a credit card or a debit card that taps directly into the credit line.
One fundamental difference between a line of credit and a credit card is the draw period, which is the limited amount of time you have to use the credit. For a credit line, this draw period can last several years, but once it closes, you can no longer access it.
There are exceptions to the draw period rule, though. For example, Tally’s line of credit is an open-ended revolving credit line, meaning it’s always there when you need it. You can transfer high-interest credit card balances to your Tally line of credit, saving you money on interest fees and helping you get out of debt quicker.
The other key differences between credit lines and credit cards are the fees. Credit lines can come with hefty origination fees that the lender deducts from the loan amount. They may also come with an annual fee.
There are three main types of lines of credit: personal, home equity and business.
What is a personal line of credit?
A personal line of credit is one of the more flexible credit lines, as it has the fewest restrictions and regulations.
Because it’s a personal credit line, the borrower can use the credit line for a variety of reasons. You can use it for a home improvement project, to buy a car, pay bills, pay off high-interest credit cards or whatever you please.
Like many personal loans, personal lines of credit are unsecured, so there’s no collateral the lender can take if you default on the loan. Being unsecured adds to its flexibility, as not everyone has collateral to put up, but it also means there’s more risk for the lender.
With this added risk comes stricter guidelines, such as a higher minimum credit score or more substantial income requirements. If your lender is a traditional bank or credit union, it may also require you to open a checking account or savings account with them.
What is a home equity line of credit?
If you can’t qualify for a personal credit line or the interest rate is too high, a home equity line of credit, often called a HELOC, might be a good option. This credit line taps into the equity in your home — the amount the home is worth versus the amount you owe on your mortgage — to give you access to funds.
Like a personal line of credit, a HELOC has many uses, including consolidating high-interest credit cards, home improvement projects, purchasing a vehicle and more.
Unlike a personal credit line, a HELOC is a secured credit line that uses your home as collateral. If you default on the HELOC, the lender could foreclose on your home. And because the lender must ensure it can cover the loan amount should you default, it will often limit the HELOC’s available credit to a percentage of the equity in the home.
The credit limit is typically 85% of the equity, according to Bank of America. So, if you have $100,000 in equity, the lender will likely offer you a HELOC up to $85,000. Because a HELOC is tied to your home, its interest may be tax-deductible, giving it an advantage over a personal line of credit.
What is a business line of credit?
A business line of credit is almost like a personal line of credit tuned for businesses. Like a personal credit line, a business credit line is often unsecured, and the borrower can use it for virtually anything related to the business. Some typical uses include facility upgrades, purchasing inventory or equipment, working capital and more.
There’s a handful of differences separating personal from business credit lines. First, some lenders require a company to be in business for a certain length of time to get approved. Second, while most are unsecured lines of credit, larger business credit lines may require assets or a certificate of deposit as collateral. Finally, a business line of credit may require annual renewals instead of having a multi-year draw period.
Should you use a credit card or credit line?
While a credit card and a line of credit are similar and can be equally helpful in a pinch, there are particular times when a credit line is a better option than a credit card.
When to use a personal credit line instead of a credit card
There are key instances when a personal credit line is far more beneficial than reaching for a credit card, namely when:
You’re planning a big purchase where the lower interest rate of a credit line will save you interest costs.
You plan to pay off a purchase over time instead of making a lump-sum payment on the next statement.
You don’t have access to a credit card with a 0% introductory balance transfer APR.
You plan to use it for debt consolidation.
When to use a HELOC instead of a credit card
There are times when a HELOC makes more sense to use than a credit card. They are as follows:
You’re increasing the value of your home with the credit line.
You’re making a large purchase and need the lowest possible interest rate.
You’re consolidating debt into one lower-interest loan.
You’re not certain how much a home improvement project will cost.
When to use a business credit line instead of a credit card
A business credit line is the outlier, as it’s the only one explicitly reserved for business purposes. Like the other lines of credit, though, there are specific circumstances when it makes more sense to use a credit line over a credit card.
Your business needs flexible working capital temporarily.
Your business is upgrading equipment over a few months or years.
Your company needs cash to complete research on a new product.
Your building needs repairs, but you don’t know the precise cost to complete them.
Choose the financing that’s right for you
When faced with unexpected expenses you don’t have the cash to cover, a credit card may be the best option. But there are certain times when a credit line is the better choice, such as when making a large purchase or starting a project without a firm price tag.
Now that you’ve gained a better understanding of how a line of credit works and what situations they are best suited for, you’re better prepared to make the right decision.