Banks offer a lot of products and services: loans, credit cards, and lines of credit. There’s a specific product for your specific need, but it may get confusing if you don’t know how each one works.
For instance, you want to get some repairs done on your home but you don’t have any money. The knee-jerk reaction would be to get a loan, but did you know you can get a line of credit for that as well?
What is a line of credit anyway?
Not too many are familiar with this product as they are with loans. This may be because banks don’t advertise it and individuals may not need it as much as businesses. Let’s review what it is, how it will help you, and if it’s the right product for you.
What Is a Line of Credit?
What is a line of credit and how does it work? A line of credit is a loan product that the bank pre-approves before the borrower needs to use it. Well, how do lines of credit work?
It allows you to access a certain amount and borrow money from it whenever the need arises, whether you need it for home improvements or for making some purchases. You then have to pay an interest on the drawn amount.
It’s similar to a personal loan in that it allows you to pay or buy something, and pay it off in monthly payments. It’s also similar to a credit card in that it only attaches an interest to the amount you’ve drawn.
If that’s so, then what makes a LOC different from these products?
Personal Loan vs Line of Credit
Getting a personal loan means borrowing a sum of money from the bank. The bank then charges you interest on the whole sum from the moment you take out that loan, regardless if you already used the money or not.
On the other hand, getting a line of credit only gives you access to an amount of money. You can then draw the exact amount of cash you need within the set limit, or you may choose to draw it all if you need it.
Unlike a loan, you don’t need to pay interest the moment you open a LOC. You don’t have to pay the interest of the amount of credit as well, just the interest of the amount you’ve already borrowed.
Credit Card vs Line of Credit
A credit card and a line of credit are similar in terms of how they work. There’s a set limit on the amount you can borrow, and you don’t accrue interest on money you haven’t used yet. They are both types of “revolving credit,” wherein you can borrow the money again once you’ve paid it off plus interest.
There are 4 key differences between them, though: interest, rewards, draw periods, and limit.
When using a credit card, you may not even have to pay interest. If you pay off the balance in full before the due date each month, your card will not incur any interest. This makes it the better option for day-to-day expenses.
A LOC doesn’t have that option. The bank automatically slaps on an interest on the amount of you’ve drawn. The good thing is that lines of credit usually have lower interest, and it doesn’t have an outrageous fee when you attempt to take out cash.
A credit card also has some rewards and programs to encourage owners to use it. Banks may offer sign-up bonuses, reward points, free stuff, and such, while those getting a line of credit won’t have the same benefits.
Then we also have what we call the draw period, which means borrowers only have a set amount of time they can access the funds. For example, a 5-year draw period will allow you to draw money in 5 years. After which, you move on to the repayment period.
Credit cards don’t have such a thing. You can use it as long as your account stays open and you have a remaining balance.
Lastly, a LOC usually has a higher limit as borrowers usually use it for big purchases, such as home renovations or business needs.
Secured Lines of Credit
There are two main types of lines of credit: secured and unsecured. What differentiates the two is the collateral. A secured line of credit requires some form of collateral, like a home, a vehicle, or another valuable asset.
For this reason, a secured LOC has a lower interest rate. Banks have more security as they can take the asset if you’re unable to make payments. Here are some examples.
Home Equity Lines of Credit
HELOC is one of the most common LOC. It allows you to draw funds for home renovation projects, repairs, and such. As a secured LOC, you usually have to use your house as collateral.
Keep in mind that as such, it gives the bank a lien on your home. Meaning, they can seize the property if you fail to pay.
HELOCs are long-term lending agreements, so the draw period is usually 10 years or so. The payment terms depend on your agreement with the bank. You might pay both interest and principal monthly, or you might pay only the interest monthly and then pay the principal at the end of the draw term.
Business Lines of Credit
In case of business LOCs, your collateral would be your business’ assets instead of a personal property. This could be a company vehicle, a business real estate, or even your office furniture.
Businesses often use this for inventory, project costs, payroll, day-to-day operations, and such. In short, it helps a business finance their needs whenever they meet cash flow problems.
It’s great for emergencies as a business is often met with emergencies no matter how stable it is. There might be a sudden spike in sales, which might require you to hire additional personnel and purchase more supplies. You might also find yourself being unable to pay a vendor or supplier because people or other establishments haven’t paid you yet.
Personal Lines of Credit
This works the same way as the other two, except the collateral is a personal asset. You can use this line of credit however you want, as long as you’re confident that you can pay it plus the interest on time.
You may have to get a checking account if the bank requires it. That way, you’ll be able to write checks from your line of credit.
Unsecured Lines of Credit
On the contrary, an unsecured LOC doesn’t require any collateral. The risk is lower for you, but it’s higher for banks. As such, the interest rates are also higher and it may be harder to apply for one.
The limit may also be lower, but it can go up to a few hundred thousand dollars. You might also have to pay some fees and even an annual fee to keep the account open, just like a credit card.
You can get unsecured personal and business lines of credit so you don’t have to tie up any personal and business assets. Even though the interest rates are higher, they are often still lower than some loans and credit cards.
Why Get a Line of Credit
Because a LOC allows you to draw money from the approved amount multiple times (as long as you don’t go over), you can borrow only the exact amount of money you need each time. For example, if you find that you need more funds, you can simply draw again. You won’t have to apply to the bank each time you need some, unlike loans.
You can also use lines of credit for things that banks won’t normally give out a loan for. Banks may offer mortgage and car loans, but you most likely won’t be able to get a wedding loan, for example. Furthermore, the interest rates are usually cheaper than loans.
When Not to Use a Line of Credit
A line of credit sounds convenient. That’s because it is, and it’s also why you should be more careful when drawing money.
One reason why you shouldn’t get a LOC in the first place is if you have an unstable income. If you’re not sure how you’ll be able to pay back the money you’ll be owing, don’t borrow it.
Another reason is that you might be able to find a loan with better rates. Note that this only works if you’re 100% sure that you won’t be needing more than the amount you need right now.
Planning to use the LOC for everyday expenses is also not a reason to get one. In this case, a credit card works best as it won’t incur any interest if you can pay the monthly dues in full.
Lastly, don’t get a LOC if you plan to use for unnecessary expenses, like treating someone to an extravagant dinner or taking vacations. If you can’t afford those stuff, don’t do them and borrow money.
The Bottom Line
So, what is a line of credit?
It’s a great financial solution if you use it right. You won’t also have problems if you’re capable of paying the loan, lest the bank seizes your property and your credit score suffers. Having access to a large amount of money might tempt you, so make sure you only get what you need.
Don’t stop there. Explore our site and read our other available guides, such as this one tackling debt consolidation with bad credit.