What Is a Line of Credit?
A line of credit (sometimes called revolving credit) is a pre-arranged amount of money lent by a financial institution. Unlike a traditional loan – which is usually a lump sum payment that is repaid on a fixed schedule – a line of credit is flexible.
The borrower can draw from the line of credit until they reach their credit limit. In the case of a revolving line of credit, they can repay borrowed funds to free up additional credit. Interest is only charged on the amount borrowed, and as long as the minimum payments are met, the borrower can adjust their repayment as needed.
While lines of credit are far more flexible than loans, both have a draw period and a repayment period. The draw period is the period in which the customer can draw money from the account. After this period ends (typically after multiple years), the repayment period begins and the customer will be required to repay the principal and interest.
How Does a Line of Credit Work?
A line of credit is similar to a credit card in that it allows customers to make purchases (on credit) on behalf of a financial institution:
The customer contacts the financial institution to apply for a line of credit.
The financial institution processes the application and runs a credit check on the customer.
The customer and financial institution determine the credit limit, interest rate, minimum payment requirements, and other details.
If the application is approved, the customer is granted the line of credit.
The customer can use the line of credit to make purchases, transfers, and other financial transactions as needed (until the credit limit is reached).
The customer will receive a statement that outlines the amount owed, available credit, minimum payment amount, payment due date, and more.
Once the credit limit has been reached, the customer can pay off some (or all) of the balance.
Line of Credit Types
Like loans and credit cards, there are many types of lines of credit, each serving a different purpose.
Secured vs Unsecured
Lines of credit can be secured or unsecured, referring to whether or not they are backed by collateral.
Secured Line of Credit
A secured line of credit is a line of credit that’s backed by collateral. This means that the borrower offers assets or property to be forfeited to the lender if they default on their line of credit. Since the lender has assurance that they will be repaid in the event of a default, secured lines of credit generally have lower interest rates than unsecured lines of credit.
Unsecured Line of Credit
An unsecured line of credit is not backed by collateral. This poses a higher risk to the lender, which is why unsecured lines of credit generally have higher interest rates than secured lines of credit.
Personal vs Business Line of Credit
Many banking products have both personal and business applications – lines of credit are no exception.
Personal Line of Credit
A personal line of credit is a predetermined amount of money lent to an individual on a revolving basis. It works similarly to a credit card and can be used for shopping, bills, or even to consolidate debt. This product is available in secured or unsecured varieties, but collateral, interest rates, and other options are up to the customer and lender to decide.
Business Line of Credit
A business line of credit is a revolving loan that provides a fixed amount of capital to be used for operating costs, business expenses, and more. This type of line of credit is generally available secured or unsecured, but exact options depend on the financial institution and borrower preferences.
Revolving Line of Credit vs Non-Revolving Line of Credit
Most lines of credit are revolving lines of credit, but not all. Both of these products establish an initial credit limit and allow the customer to borrow and make payments as needed, but there is a key distinction between the two.
Revolving Line of Credit
A revolving line of credit is an open-ended, flexible loan with a fixed credit limit. The term “revolving” refers to the borrower’s ability to continue drawing from the line of credit as funds are repaid. Examples of revolving lines of credit include:
Personal lines of credit
Business lines of credit
Home equity lines of credit
Non-Revolving Line of Credit
Unlike a revolving line of credit (that allows the customer to borrow and repay funds indefinitely), available credit on a non-revolving line of credit does not replenish as payments are made. Once the borrowed funds have been repaid in full, the account is closed.
Home Equity Line of Credit
A home equity line of credit (HELOC) is a type of secured line of credit that uses equity in the borrower's home as collateral. Like other types of lines of credit, the borrower will have an established credit limit, can draw from the account as needed, and will only pay interest on borrowed funds. A HELOC can have much lower interest rates than other types of lines of credit because it is backed by significant collateral.
Advantages and Disadvantages of Lines of Credit
Like most financial products, lines of credit have a number of pros and cons that should be taken into consideration.
Advantages of Lines of Credit
Flexible. Lines of credit allow you to choose a credit limit and free up available credit as you make payments.
Pay for what you use. Unlike loans, you’ll only pay interest on the amount you use.
Adjustable repayment. Adjustable repayment terms allow you to make payments when it’s convenient.
Competitive rates. Interest rates are generally lower than credit cards and loans, especially on secured lines of credit.
Easy access. Lines of credit work similar to bank accounts, allowing you to draw from them as needed.
Few restrictions. While auto and student loans are earmarked for specific purposes, lines of credit have much fewer restrictions.
Builds credit. Making payments on time – and using as little credit as possible – can help you increase your credit score.
Disadvantages of Lines of Credit
Potential for higher interest. Lines of credit often have variable interest rates. If rates rise, this might lead to an increase in payable interest.
Lower limits. Lines of credit generally have lower credit limits than loans, but there are exceptions.
Risk. As with any type of loan, there is always a risk of the borrower defaulting and being unable to repay borrowed funds. This could lead to forfeited assets, a lower credit score, garnished wages, liens, and other issues.
Can be tempting. With instant access to a large sum of money and no immediate repayment requirements, it can be easy to overspend and get into financial trouble.
Requires good credit. Most lines of credit require the applicant to have good credit, especially if the line of credit is unsecured.
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