What is a line of credit? Borrow money with this flexible financing option
A line of credit allows you to borrow the money that you need and only pay interest on what you use.
Contributing Writer at Tally
August 6, 2020
If you're familiar with how a credit card works, then you already have a good understanding of credit lines.
So, what is a line of credit? A line of credit (LOC) is a predetermined amount of money that a lender, such as a credit union or bank, has agreed to lend you. You can draw from the line of credit when needed, up to the maximum amount granted by the lender. You then pay interest on the funds that you borrow.
This is similar to a credit card, which carries a credit limit. Your credit limit is the maximum amount the bank has authorized you to spend on the card. You don't have to use your credit card, but if you do, you're required to pay back the funds that you borrow. Once you pay it back, you can reuse that money again.
In this article, we'll cover everything you need to know about lines of credit so that you can determine whether they're a worthwhile borrowing tool for you.
What is a line of credit?
An LOC is a predetermined amount of money that a bank or credit union has agreed to lend you. You have access to the funds immediately, although you are not required to use them. You can borrow up to the maximum amount authorized by the lender. Once you repay the money, it becomes available credit that you can use again.
For instance, let's say you have a $10,000 line of credit. You borrow $5,000 and pay back $1,000 in principal per month. After the initial purchase, your available credit is $5,000. After the first monthly payment, you have $6,000 in available credit.
Banks begin charging interest as soon as the money is borrowed. Many lines of credit come with variable interest rates, meaning the interest rate can fluctuate over time.
For example, if you take out a fixed-rate mortgage with an interest rate of 4%, you know that you'll only pay 4% interest throughout the life of the loan.
Now, let's say you take out a line of credit with a variable interest rate. Your interest rate starts out at 2% but it rises to 8% before the end of the loan terms.
Variable interest rates are not set by banks and lenders arbitrarily. They depend on benchmarks, such as the federal funds rate, to determine how much the interest will rise or fall during each adjustment period. Your bank adjusts your minimum monthly payment based on how much you owe and the current interest rates.
The benefits of using a line of credit
There are a few noteworthy advantages of using a line of credit. For one, you only have to pay interest on what you borrow, not on the entire line of credit.
This is different from a loan, like a mortgage, where you receive a lump sum upfront and then have to pay back the entire amount plus interest. If you don't use the line of credit funds, you won't have to pay interest on the unused balance.
Thus, this credit option also provides flexibility for your borrowing needs. It would not be feasible for you to take out a small personal loan every month, repay it, and then take out another loan the following month. But with a line of credit, the money is available for you if you need it.
Lines of credit provide you with a bit of extra cash flow, allowing you to cover things like variable monthly income inconsistencies. They also allow you to fund projects where it would otherwise be difficult to determine exactly how much you need in advance. A home improvement project or the closing costs when purchasing a new home are excellent examples of this. A wedding, where you may need a large cash advance for a deposit upfront, is another example.
Business owners often take out lines of credit to get the working capital they need to grow the business. The same concept can apply to personal lines of credit. You could also use a line of credit to pay down other debt.
For example, let's say you have student loans with a 3% annual percentage rate (APR). You open a line of credit with a 1.7% APR. In this case, it would cost less to pay the interest on the line of credit than the student loan.
You could take out a line of credit for the remaining student loan amount, use the cash to pay off your student loans, and then pay down the line of credit.
The downsides of using a line of credit
Lines of credit can be useful borrowing tools, but you need to know how to use them correctly and be aware of the potential pitfalls they carry.
The first is that you need to repay all of the money you borrow. The payback terms are spelled out when you first open the line of credit. If you're not careful, you can easily burn through your credit line and find yourself struggling to repay the balance.
The same concept applies to credit cards. You shouldn't treat credit lines as free money. And the interest that you pay on an LOC is usually not tax-deductible.
Many financial institutions charge a maintenance fee if you don't use the line of credit. So while you may find an LOC useful to help keep cash on hand, you may need to pay a monthly or annual fee if you don't put these funds to good use. This could encourage some borrowers to spend unnecessarily.
The other downside is that a line of credit may not be the most accessible borrowing option. Lenders check your credit history to determine your creditworthiness. If you have a FICO credit score above 690, you may qualify for approval. But if your score is below 690, your LOC will come with higher interest rates, if you can get approved at all.
The last potential problem with an LOC is that you can risk losing your home or other forms of collateral, depending on whether you take out a secured or unsecured line of credit.
Secured vs. unsecured LOCs
When opening a line of credit, you need to determine whether you would like it to be secured or unsecured. A secured line of credit is backed by collateral, such as:
Stocks or investment properties that you own
Funds in a savings account
By putting up collateral, you are guaranteeing to the bank that you will repay your LOC. If not, the bank is authorized to seize the collateral assets as a way of collecting repayment.
Secured LOCs are often tempting because they come with lower interest rates and higher limits. But if you started missing your payments, your collateral is at risk.
The other option available is an unsecured line of credit. Unsecured lines of credit do not carry collateral backing. A majority of LOCs are unsecure. Unsecured lines of credit tend to be expensive because of the high-interest rates that come with them.
Revolving vs. non-revolving LOCs
The other thing to pay attention to when opening an LOC is whether it's revolving or non-revolving. Most LOCs are revolving: Once you make a repayment, your pool of available credit replenishes. Our example above, where we made $1,000 monthly payments, is an example of revolving credit.
Non-revolving credit lines do not replenish. You do not have to take all of the funds upfront like you would with a loan. However, once you use the funds, they are no longer available. Once you pay off the line of credit in full, the account closes.
Types of credit lines
Now that you have a better understanding of how lines of credit work, let's take a look at some of the options available to you.
Personal line of credit
A personal line of credit is the most common option available. These LOCs are unsecured and revolving. Lenders want to see a sound credit report without any defaults, along with a FICO Score above 690 and steady income.
Although there are plenty of LOCs offered by online lenders, Tally is one of the best personal lines of credit for debt consolidation. If you have a FICO Score above 660, Tally works with you to assess your credit cards and existing debt, and determine if you are eligible for a personal line of credit with a lower APR than you're currently paying.
Tally then works as a form of debt consolidation, allowing you to pay off outstanding debts more quickly while making one single monthly payment. Tally can improve your money management skills, allowing you to pay down debt more quickly so that you can start working toward your savings goals.
Home equity line of credit (HELOC)
A HELOC is a secured LOC that acts as a second mortgage. You put your home up as collateral and can take out a line of credit that's worth the market value of your home minus the amount you still owe on your first mortgage.
Home equity lines of credit are unique in that they have draw and repayment periods. The draw period is the time in which you're allowed to borrow and access funds. You can repay funds and reuse them during this time. After the draw period ends, you enter the repayment period. You can no longer use the credit and will need to make minimum payments monthly to pay back what you owe.
Business line of credit
Business lines of credit are for companies looking for extra cash on an as-needed basis. Lenders will carefully evaluate the company's market value, profitability, and risk to determine eligibility. These LOCs can be either secured or unsecured, although they will always have variable rates. They could be useful in providing small businesses with the cash they need to get started without having to deal with investors.
Use a line of credit as a powerful borrowing tool
Lines of credit can be a useful borrowing tool to boost your cash flow. Whether you're an individual looking to complete a home renovation, someone looking to strategically pay down debt, or a small business owner looking to grow your company, an LOC can provide you with the flexibility to do so.
When taking out an LOC, you need to be aware of some of the risks. Secured LOCs can yield better interest rates but expose your assets to seizure if you don't make timely repayments. Remember: A line of credit is not free money. You need to repay any amount you borrow, plus interest.