A line of credit (LOC) is a financial tool that allows individuals and businesses to borrow a pre-approved amount of money as needed, up to a specified limit. It gives ongoing access to funds, allowing you to draw what you need, when you need it, and only pay interest on the amount you borrow.
It's like having a personal financial safety net that you can access when unexpected expenses arise or when you need extra funds for specific purposes.
But before you apply for a line of credit, it's crucial to understand how they operate, plus their benefits and potential drawbacks. In this article, you'll find everything you need to know about lines of credit.
Money matters—but so does happiness. Browse these amazing opportunities on The Muse and find the perfect fit for you »
What is a line of credit?
A line of credit is a flexible way of borrowing money that allows you to access funds up to a pre-approved limit, whenever you need them.
A line of credit works sort of like a credit card: You can borrow money as needed up to your credit limit, repay the borrowed amount, and borrow again as long as the line of credit remains open. Interest rates on lines of credit interest typically are better than credit card interest rates. This flexibility makes it an ideal solution for certain financial surprises.
“Lines of credit provide invaluable flexibility for covering irregular, unavoidable costs like medical emergencies or urgent home repairs,” says Andrew Gosselin, a CPA and Chief Financial Strategist at The Calculator Site. “They also serve as handy gap financing for projects with fluid or indeterminate total costs.” (Think: Home renovation.)
How does a line of credit work?
A line of credit typically has two main phases: the draw period and the repayment period. During the draw period, you can access the funds and pay interest only on the amount you’ve borrowed. Once the draw period ends, the repayment period begins, where you repay any remaining balance, often with added interest.
Some lines of credit are revolving, meaning you can borrow, repay, and borrow again, while others are non-revolving, meaning once you repay what you've borrowed, the line closes and cannot be reused. Non-revolving lines also have a fixed amount and repayment schedule.
When you're approved for a line of credit, the lender sets a credit limit based on your creditworthiness, income, and other financial factors. You can draw funds up to this limit, but unlike a traditional loan, you don’t receive the entire amount all at once. Instead, you borrow only what you need, when you need it.
Borrowing and repayment process
The borrowing process is straightforward. You can withdraw funds up to your approved credit limit during the draw period, which is typically a set period, such as five or 10 years. You’ll only pay interest on the amount you actually borrow, not the entire credit limit. During this period, you may be required to make interest-only payments or small minimum payments, depending on the terms of your line of credit.
After the draw period ends, the repayment period begins. During the repayment phase, you'll have to repay any outstanding balance along with interest. The interest rate on a line of credit may be variable, meaning it may change over time, which could affect your monthly payments. It’s always smart to understand how interest is calculated so that you’re confident you can afford the repayments, especially if the rate fluctuates.
Line of credit vs loan
Right now, you may be thinking, “What’s the difference between a loan and a line of credit?” The main difference lies in flexibility and repayment structure. With a traditional loan, you receive a lump sum of money upfront and make fixed monthly payments until the loan is repaid in full, typically at a fixed interest rate. This makes traditional loans predictable, as you know exactly how much you owe each month.
In contrast, a line of credit offers more flexibility because you can borrow as needed and repay on your own schedule, up to the end of the draw period. This flexibility can be advantageous for managing cash flow or handling unexpected or one-off expenses—but it also requires careful management to avoid overspending or accumulating more debt than you can handle.
Line of credit vs credit card
While both a credit card and a line of credit offer revolving credit, a line of credit is often better suited for larger expenses or situations where you need access to cash, such as home improvements or managing cash flow in a business. With a line of credit, you can take out cash advances without the high cash-advance fees that many credit cards charge.
A credit card is a type of revolving credit that lets you make purchases up to a credit limit. You can carry a balance from month to month, but you'll be required to make at least a minimum payment, and interest will accrue on any unpaid balance. Credit cards are more convenient for smaller, everyday transactions and frequently offer the benefit of rewards and cashback programs.
Types of lines of credit
Lines of credit can be broadly categorized into two types: secured and unsecured.
Secured line of credit
A secured line of credit is backed by collateral, meaning you pledge an asset to the lender in case you can’t repay the borrowed amount. A common example is the home equity line of credit (HELOC), where your home acts as the collateral. “Putting your collateral on the line reduces risk for lenders, allowing them to offer much lower interest rates that save you money over the long run,” Gosselin says. However, it's important to note that if you default on the debt, the lender can seize your collateral.
Unsecured line of credit
On the other hand, an unsecured line of credit doesn’t require any collateral. “Those without collateral must weigh an unsecured line's higher interest rates against the advantage of no repossession risk,” Gosselin says. “Your overall creditworthiness also heavily dictates the rates and terms you receive, especially for unsecured products.”
Specialized lines of credit
Specialized lines of credit offer tailored borrowing solutions, providing flexibility and unique benefits. Let’s explore these options:
Personal line of credit
A personal line of credit is an unsecured loan that allows you to borrow money up to a set limit and repay it over time. This type of line of credit is often used for personal expenses, such as home renovations, debt consolidation, or unexpected costs like medical bills.
To qualify, you'll typically need a good credit score, a stable income, and a low debt-to-income ratio. Personal lines of credit offer the flexibility to withdraw money as needed and pay interest only on the amount you use, making them a versatile option for managing personal finances.
Business line of credit
A business line of credit works similarly to a personal line of credit but is tailored for business needs. It allows businesses to borrow up to a certain limit and repay over time, providing much-needed flexibility for managing cash flow, purchasing inventory, or covering unexpected expenses.
To qualify for a business line of credit, lenders typically look at the business's revenue, credit history, and financial stability. The main benefit of a business line of credit is that it enables companies to access funds quickly without the need to reapply each time, which can be especially helpful for managing short-term financial challenges.
Other specialized lines of credit include:
- Demand line of credit: Allows the lender to call in the loan at any time, typically used for short-term borrowing needs
- Securities-backed line of credit (SBLOC): Lets you borrow against the value of your investment portfolio, offering lower interest rates but with the risk of having to sell off securities if the market drops
- Overdraft line of credit: Is linked to your checking account and covers overdrafts, preventing bounced checks and overdraft fees
Each of these lines of credit has unique terms and benefits, catering to different financial situations and goals.
Pros and cons of lines of credit
Is line of credit a good thing? To figure out, it's essential to weigh the advantages and disadvantages, so you can determine if it suits your financial needs and goals. Here’s a breakdown of the pros and cons:
Advantages
- Flexibility: You can borrow only what you need, when you need it, without having to reapply each time. This makes it an excellent option for handling irregular expenses or managing cash flow.
- Lower interest rates than credit cards: This is especially if it's a secured line of credit. It can save you a considerable amount of money on interest payments, particularly for large expenses or when borrowing over a longer period.
- Interest charges on the amount used: Unlike traditional loans, where interest is charged on the full amount from the start, with a line of credit, you only pay interest on the money you actually use. This can make a line of credit a cost-effective option if you don’t need to borrow a large amount all at once.
Disadvantages
- Risk of overspending: The flexibility to borrow as needed can also be a downside. “The open-ended borrowing capability creates ample temptation to overspend and accrue unmanageable debt,” Gosselin says. It’s easy to lose track of your spending, leading to a balance that becomes difficult to repay.
- Variable interest rates: “Applicants must exercise caution with lines of credit featuring variable interest rates that can fluctuate unpredictably,” Gosselin says. This variability can make it hard to predict your monthly payments, potentially leading to financial strain if rates increase significantly.
- Impact on credit score: “A line of credit's impact on your credit score largely mirrors that of credit cards when it comes to credit utilization,” Gosselin says. High utilization suggests you’re over-reliant on borrowed funds, which can hurt your score. “Payment history is another key factor, with on-time line of credit payments helping your score just like other loans, and late payments harming it significantly.”
When using a line of credit might be a good idea
A line of credit can be a powerful financial tool when used appropriately. It’s ideal for situations that require flexibility, such as emergencies, home renovations, or managing cash flow for a business. In these cases, the ability to borrow as needed—without taking out a full loan upfront—offers a significant advantage.
For example, a home equity line of credit could be perfect for a homeowner who wants to make gradual home improvements without committing to a lump sum loan. Similarly, a business line of credit can help manage unexpected expenses or temporary cash flow gaps.
Be aware of the pitfalls of lines of credit
However, deciding whether to use a line of credit or another financing option requires careful consideration. If you’re contemplating a significant, one-time purchase or expense, a traditional loan might be more appropriate, as it offers a structured repayment plan and often lower interest rates. On the other hand, if you anticipate needing funds intermittently or prefer flexibility, a line of credit could be a better fit.
“Many applicants gloss over the terms and conditions, leaving them blindsided by fees or unfavorable interest rates down the line,” Gosselin says. “Ignoring your current credit score beforehand is also unwise, as a low score limits your options and leads to costlier borrowing.”
Avoid overusing a line of credit
Furthermore, Gosselin warns against overusing a line of credit, which can lead to financial trouble: “The primary danger is accumulating more debt than you can affordably manage through the minimum monthly payments,” he says. “Lines of credit are deceptively easy to draw from repeatedly for discretionary wants beyond true needs.”
The consequences can quickly become overwhelming. “Rapidly escalating balances driven by unbridled spending render the debt overwhelming to repay,” he says. “This excessive credit utilization also severely impacts your credit scores, closing doors on future loans/mortgages. Relatedly, interest charges steadily compound on unpaid line balances, amplifying total borrowing costs over time.”
How to get a line of credit
Getting a line of credit involves meeting certain criteria that vary depending on the type of credit you’re seeking. Usually, lenders look at:
- Credit score: A higher credit score indicates that you’re a reliable borrower, increasing your chances of approval and potentially securing better interest rates. A good credit score is often a prerequisite, especially for unsecured lines of credit.
- Income: Lenders want to ensure you have a stable source of income to repay the borrowed amount. They will assess your income relative to your existing debts to determine your debt-to-income ratio, which helps assess your ability to handle additional debt.
- Collateral: For secured lines of credit, such as a HELOC, lenders require collateral—often in the form of home equity or other valuable assets—to reduce the lender's risk, making approval easier even if your credit score isn’t perfect.
Step-by-step guide to applying for a line of credit
- Evaluate your needs: Determine the type of line of credit that best suits your needs—personal, business, or HELOC.
- Check your credit report: Review your credit report to ensure there are no errors or discrepancies that could affect your application.
- Gather necessary documentation: Prepare your income statements, proof of employment, credit report, and any collateral documentation if applying for a secured line of credit.
- Research lenders: Look into different types of lenders, such as banks, credit unions, online lenders, and other financial institutions. Compare their terms, interest rates, and fees to find the best fit for your financial situation.
- Submit your application: Fill out the application with accurate information and submit it to the chosen lender. Be prepared to provide any additional information they might request.
- Review the offer: Once approved, review the terms and conditions carefully to ensure they align with your needs. Make sure you understand the repayment terms, interest rates, and any fees associated.
- Accept and use your line of credit: If you agree with the terms, accept the line of credit and use it responsibly, keeping track of your borrowing and repayment to maintain a healthy credit score.
What if the line of credit request gets denied?
If your request for a line of credit is denied, the first step is to understand the reason—whether it stemmed from poor credit history, insufficient income, outstanding debts, or another factor.
“Pull your current credit reports and review them thoroughly for any errors or negative items unfairly impacting your scores that you can dispute and have removed,” Gosselin says. “From there, work on improving your overall credit profile.”
To improve your chances of getting approved for a line of credit, focus on:
- Paying down existing debts: Reduce your current debts to improve your debt-to-income ratio, which can increase your attractiveness to lenders.
- Avoiding missing payments: Make sure to pay all your bills on time to build a solid payment history, as missed payments can negatively affect your credit score.
- Reducing credit utilization rates: Aim to use less of your available credit to lower your credit utilization rate, which is a key factor in boosting your credit score.
As your scores improve, you can then reapply with the original lender or shop your application around with other banks or credit unions. Lacking approved collateral, consider a secured line of credit.
FAQs
Can you withdraw cash from a line of credit?
Yes, you can withdraw cash from a line of credit, either by writing checks, transferring funds to your bank account, or using a debit card linked to the line of credit. This flexibility is one of the advantages of having a line of credit, as it allows you to access funds as needed, up to your approved credit limit.
Is a line of credit better than an installment loan?
A line of credit offers flexibility, allowing you to borrow and repay repeatedly up to a set limit, which can be beneficial for ongoing expenses or emergencies. In contrast, an installment loan provides a lump sum with fixed monthly payments, making it ideal for one-time expenses where a set repayment schedule is preferred. Your choice should be based on your financial goals, needs, and repayment ability.
How much is the interest rate for a line of credit?
The interest rate for a line of credit can vary significantly depending on the type of line of credit, the lender, and your creditworthiness. Generally, secured lines of credit, like a home equity line of credit (HELOC), tend to have lower interest rates than unsecured lines of credit. It’s important to compare rates from different lenders and understand the terms before applying.
Can you get a line of credit for bad credit?
Yes, you can get a line of credit with bad credit, but it may come with higher interest rates and less favorable terms. Lenders may offer secured lines of credit or specialized products for individuals with poor credit histories. It’s crucial to compare different options and consider improving your credit score to qualify for better rates and terms.
Is it possible to find an instant approval personal line of credit?
Yes, it is possible to find a personal line of credit with instant approval, particularly through online lenders. These lenders often provide a quick, preliminary decision based on a review of your credit score, income, and financial situation. However, instant approval usually means you'll receive a preliminary offer, and final approval may still require further documentation and verification. It's important to read the terms carefully and ensure you meet all the criteria before committing.