Personal line of credit: Get flexible cash when you need it
A personal line of credit offers flexibility, but it's not a one-size-fits-all option.
Contributing Writer at Tally
July 29, 2020
Whether you need cash to consolidate debt, buy a car, buy a home, start a business or handle an emergency, you can find a loan that meets your financial needs.
A personal line of credit is a loan that offers distinct features, including flexible monthly payments and few usage limitations. But this flexibility doesn't mean a personal line of credit is the right option for everyone.
Below, we’ll outline the basics of a personal line of credit to help you to determine if it meets your financial needs.
What's a personal line of credit?
A personal line of credit is similar to a credit card but has some key differences. It's a revolving credit account, which means you can use it multiple times to pay for goods and services. A personal line of credit also has a credit line limit, which is similar to a credit limit on a credit card.
When you are approved for a personal line of credit, the lender gives you checks and a debit card you can use to access your funds. You can write the checks or use the debit card just as you would use a checking account. You can also use the debit card to withdraw cash from the ATM.
Some of the key characteristics to pay close attention to when considering a personal line of credit include its draw and repayment periods, interest rate, usage limitations, whether it's secured or unsecured and related fees.
Personal line of credit phases
Most personal lines of credit have two distinct phases: the draw period and the repayment period.
The draw period is the first phase of a personal line of credit. This is when you can use the line of credit to make purchases or pay for services. This period varies based on the terms of the line of credit.
During the draw period, you make payments on the balance you borrow. Most lenders give you the option of making interest-only payments or principal and interest payments while in the draw period.
If you have no balance on the line of credit at the end of the draw period, it closes.
If the draw period ends with a balance, you enter the repayment period. During this period, you can no longer draw money from the line of credit and must start making principal and interest payments.
Like the draw period, the repayment period also varies based on the terms of the line of credit.
Personal lines of credit charge interest, which is what the lender charges you to lend you money. Unlike most personal loans, a personal line of credit usually has a variable interest rate, meaning the interest rate may change over the life of the loan.
A personal line of credit with a variable interest rate may start with an introductory interest rate that's significantly lower than a fixed-rate loan. The downside is the introductory rate is only temporary and can eventually exceed a fixed-rate loan's interest rate.
Fortunately, a variable interest rate doesn't change on a whim. Instead, it follows the rise and fall of The Wall Street Journal's prime rate, which is based on the federal funds rate and a survey of 30 of the largest banks in the U.S.
When the interest rate changes, it applies only from that moment forward and not retroactively.
When weighing your line of credit options, you want to consider more than just the initial interest rate. You also want to consider the rate-adjustment period, periodic rate cap, lifetime rate cap and a potential fixed-rate option.
Lines of credit with variable interest rates won't change without your knowledge. The loan agreement outlines its preset rate-adjustment periods. The lender can only change the interest rate on your line of credit during these periods.
Typically, rate-adjustment periods occur at the beginning of each month. However, lenders may set quarterly, semi-annual or other rate-adjustments periods.
Periodic rate cap
The periodic rate cap is expressed as percentage points and limits the number of percentage points your loan can increase during a rate-adjustment period.
For example, if your line of credit has a 1-percentage-point periodic rate cap, the lender can't raise the interest rate more than 1 percentage point during any rate-adjustment period.
Lifetime rate cap
The lifetime rate cap is also expressed as percentage points. It’s the cap on the overall number of points the lender can raise your interest rate by during the life of the line of credit.
For example, if you take out a personal line of credit with a 10% initial interest rate and a 10-percentage-point lifetime rate cap, the interest rate will never exceed 20%.
Some lenders give you the option of converting your line of credit balance to a fixed-rate loan. You can only make this conversion during the draw period, and the fixed interest rate will likely be notably higher than the initial variable rate.
Despite the higher interest rate, converting into a fixed-rate loan can prevent potential payment increases as the variable rate rises.
The line of credit terms will tell you whether a fixed-rate option is available and outline its terms.
A personal line of credit offers flexibility by providing multiple repayment options in the draw period, but that can come at a cost of monthly and annual fees.
A monthly fee, sometimes referred to as a maintenance fee, is generally small but can add up to hundreds of dollars each year. An annual fee is a larger charge, but it only comes once a year.
Most lenders charge either a monthly or an annual fee — they rarely charge both. Some lenders charge no fees. You can find these fees in your loan agreement.
When borrowing money, you must consider what you stand to lose if you default on the loan. Some loans are secured, including home equity loans, home equity lines of credit, auto loans and business lines of credit. This means you use collateral by putting up something valuable to secure the loan. If you default on the loan, the lender can seize the property with relative ease to limit its losses.
A personal line of credit is generally unsecured, which means you don’t need collateral for the loan. While the lender may still seize your property if you default on the loan, they must first get the judgment of a court.
Because unsecured lines of credit have no collateral securing the line of credit, lenders who offer personal lines of credit often have strict creditworthiness requirements and higher interest rates than secured lines of credit. They generally require a good credit score and a low debt-to-income ratio.
What can I use a personal line of credit for?
There are generally few limits on how you can use a personal line of credit. This makes them far more flexible than auto loans, home improvement loans, debt consolidation loans and other specific-use loans.
Check your loan terms to see what restrictions, if any, the lender puts on the funds.
Some common uses for personal lines of credit include:
Home improvement projects
College tuition, fees and other expenses
A personal line of credit can also act as a security net during a financial downturn, similar to what we're experiencing during the COVID-19 outbreak. It can provide funds should the financial crisis cause you to lose your job while you’re without sufficient emergency savings.
If you never draw cash from the line of credit, the only cost for this added sense of security may be the monthly or annual fee.
Is a personal line of credit the same as a personal loan?
Personal lines of credit and personal loans have a lot in common. Both offer quick access to flexible funds, are generally unsecured and require good credit scores for approval. But their similarities end there.
One key difference between a personal line of credit and a personal loan is they’re categorized as different types of debts.
A personal line of credit is revolving credit. This means you can reuse the credit as many times as you'd like. The only limitations are the credit line limit and the length of the draw period. As revolving credit, you also pay only for the amount you draw from the line of credit.
A personal loan is an installment loan. The lender pays the full loan amount once the loan closes. You also immediately begin repaying the loan through equal monthly payments.
Another key detail separating a personal line of credit from a personal loan is the line of credit's phasing structure.
A personal line of credit has a pair of phases: draw and repayment. The draw phase allows you to use the credit line and make interest-only payments for a set period before you enter the repayment phase. In the repayment phase, you make full principal and interest payments.
A personal loan goes immediately into repayment after the lender disburses the funds. Barring any special conditions on a personal loan, the repayment period requires full principal and interest payments.
Interest rates are another big difference between a personal line of credit and a personal loan.
A personal loan generally comes with a fixed interest rate. This means the interest rate you and the lender agree upon will never change.
Most personal lines of credit come with a variable interest rate, which can change during adjustment periods. However, some lenders add extra flexibility to their personal lines of credit by offering fixed-rate interest.
Fees are often overlooked when applying for a loan, but they can add up quickly and impact your minimum monthly payments.
Personal loans generally include at least an upfront origination fee, which you can pay separately or roll into your loan. Though rare, some may also include an application fee, which you pay when you apply for the loan.
Personal lines of credit generally have no upfront fees, but some charge monthly or annual fees.
Is a personal line of credit right for you?
Determining whether a personal line of credit is right for you or not requires a deep dive into your financial needs and goals. Then, compare your needs to what a line of credit can offer you.
When a personal line of credit may be right for you
If the following points are true for you, you might consider a personal line of credit.
You have an immediate need for flexible cash.
You want a lower interest rate than a credit card can offer.
You're uncertain exactly how much cash you need.
You only need backup funds.
You want the lowest possible initial minimum monthly payments.
You lack the equity for a home equity line of credit (HELOC).
You don't want to put a vehicle or home up as collateral.
You have a good credit score.
When a personal line of credit may not be right for you
There may be some reasons a personal line of credit isn’t the best option for you. If one or more of the following descriptions applies to you, you may want to look at other possibilities.
A personal line of credit may not be right for you if:
You lack a good credit score.
You need access to a line of credit for longer than the draw period allows.
You want a fixed interest rate.
You know the exact amount you need to borrow.
You have enough home equity to qualify for a HELOC.
You tend to max out credit cards when you have them.
Your priority is a low interest rate.
If this sounds like you, there are alternative options. Let’s take a look.
Personal line of credit alternatives
A personal line of credit isn't the only revolving line of credit available. If a personal line of credit isn't right for you, there are several alternatives to consider.
Home equity line of credit (HELOC)
A HELOC is a secured line of credit that uses your home as collateral. It has stricter approval guidelines that include a home appraisal and puts your home at risk of foreclosure if you default. On the positive side, it usually offers a lower interest rate than a personal line of credit and will offer longer repayment terms.
Though a HELOC is a secured line of credit with equity requirements, it works similarly to a personal line of credit.
Business line of credit
If you own a business and plan to use the line of credit for business needs, a business line of credit may be an option. Like a HELOC, a business line of credit requires collateral. You can use virtually any business asset for collateral, including equipment, the business’ building, fleet vehicles and more.
Because there's collateral, a business line of credit generally has a lower interest rate than a personal line of credit. The downside is you risk your business’s assets if you default on the loan.
Besides its lower interest rate and collateral requirements, a business line of credit works like a personal line of credit.
Like a personal line of credit, a credit card offers flexible access to cash, and you only pay for the amount you spend plus interest and annual fees.
Unlike a personal line of credit, a credit card has no draw period, so you can continue to use it until you close the account or reach your credit limit. And other than secured credit cards, which require a security deposit, credit cards also have no collateral requirements.
On the downside, credit cards tend to have much higher interest rates than personal lines of credit. Also, you cannot convert them to a fixed interest rate.
Flexible cash when you need it
A personal line of credit gives you flexible cash when you need it. Also, it can even offer fallback cash when your immediate financial future is uncertain. Despite this flexibility, it's not the right option for everyone due to its relatively unpredictable interest rates, a potential annual fee and a limited draw period.
Compare the benefits and drawbacks of a personal line of credit to determine if it's the right option for you. If it doesn't fit your needs, there are other revolving credit options on the market. Alternatively, you can consider a personal loan or other installment loan options that suit you.
Start researching today to see which options you’re eligible for and what best suits your needs.