What is A Line of Credit? Overview and How It Works

A line of credit (LOC) is a set amount of money that can be borrowed at any time. In the case of an open line of credit, the borrower can take money out as needed until the maximum is reached, and as money is repaid, it can be borrowed again.

A line of credit (LOC) is a contract between a financial institution (typically a bank) and a consumer that establishes the maximum loan amount the customer can take out. The borrower can use the funds from the line of credit whenever they want as long as they don’t go over the agreed-upon maximum amount (or credit limit).

All LOCs have a specific amount of money that can be borrowed, paid back, and borrowed again as needed. The lender determines the amount of interest, the size of instalments, and other conditions.

Some credit lines contain the ability to write checks (drafts), while others include a credit or debit card. A LOC can be secured (with collateral) or unsecured (with no collateral), with unsecured LOCs often having higher interest rates.

Why Choose A Line of Credit?

The fundamental advantage of a line of credit is its built-in flexibility. Borrowers have the option of requesting a specific amount, but they are not required to utilize it all.

Rather, individuals can customize their LOC expenditure to their specific needs, paying interest only on the amount they draw, not on the whole credit line.

Borrowers can also change their payments amounts based on their budget or cash flow as needed. They can pay off the entire sum at once, for example, or only make the minimum monthly payments.

The Categories of Line of Credit

There are 4 categories of Line of credit: secured and unsecured, revolving and nonrevolving.

The majority of credit lines are unsecured loans. This means the borrower is not pledging any collateral to the lender as security for the LOC.

A home equity line of credit (HELOC), which is backed by the equity of the borrower’s home, is one notable exception. Secured lines of credit are appealing to lenders because they give a mechanism to reclaim the loaned monies in the case of nonpayment.

Secured lines of credit are appealing to individuals and company owners because they often provide a higher maximum credit limit and cheaper interest rates than unsecured lines of credit.

Unsecured credit lines are also harder to obtain and frequently necessitate a better credit score or credit rating. Lenders try to offset the heightened risk by limiting the amount of money that can be borrowed and charging higher interest rates. One of the reasons credit cards have such a high annual percentage rate (APR) is this.

RELATED:  Marcus by Goldman Sachs Personal Loan Reviews

Credit cards are unsecured lines of credit, with the credit limit—the maximum amount you can charge on the card—representing the card’s parameters. When you start the card account, however, you do not have to pledge any assets. If you start skipping payments, the credit card company has little recourse against you.

A revolving account, also known as an open-end credit account, is commonly referred to as a line of credit. Borrowers can spend the money, return it, and spend it again in a virtually endless rotating loop under this arrangement. Instalment loans, such as mortgages and car loans, differ from revolving accounts such as lines of credit and credit cards.

Consumers who take out instalment loans borrow a specific amount of money and repay it in equal monthly payments until the loan is paid off. Consumers who have paid off an instalment loan are unable to use the funds again unless they qualify for a new loan.

Non-revolving credit lines have the same characteristics as revolving credit lines (or a revolving line of credit). A credit limit is set, funds can be used for various reasons, interest is levied as usual, and payments can be made at any time.

There is one key exception: after payments are completed, the pool of available credit does not replenish. After you’ve paid off your line of credit in full, the account will be cancelled and you won’t be able to use it again.

Personal lines of credit, for example, are sometimes issued by banks as an overdraft protection plan. An overdraft plan tied to a checking account can be set up by a banking customer. If a customer’s checking account balance is exceeded, the overdraft prevents a check from being bounced or purchase from being refused. An overdraft, like any other line of credit, must be repaid, plus interest.

Uses of Lines of Credit

In general, lines of credit aren’t meant to be used to cover one-time purchases like houses or cars—what mortgages and vehicle loans are for—but they can be used to purchase products that a bank might not ordinarily underwrite a loan for. Individual lines of credit are most typically used for the same purpose as company lines of credit: to smooth out the peaks and valleys of unpredictable monthly income and expenses or to fund projects when exact funding requirements are impossible to predict in advance.

Consider a self-employed person whose monthly revenue is inconsistent or who has a large, often unpredictably long time between doing the work and receiving payment. While this person may often use credit cards to deal with cash flow problems, a line of credit can be a more cost-effective choice (it typically has lower interest rates) with more flexible repayment schedules.

RELATED:  What is the Average Credit Limit By Income?

Lines of credit can also be used to support expected quarterly tax payments, especially if the timing of the “accounting profit” and the actual receipt of cash differs. In brief, lines of credit can be useful in situations where there will be recurring financial outlays, but the amounts won’t be known ahead of time and/or the merchants won’t accept credit cards, as well as instances requiring big cash deposits—weddings are a good example.

Similarly, during the housing boom, lines of credit were frequently used to support house improvement or refurbishment projects. People would typically seek a mortgage to purchase a home and a line of credit to assist fund any improvements or repairs that were required.

Personal lines of credit have also become available as part of overdraft protection policies offered by banks. While not all banks are willing to describe overdraft protection as a loan product (“It’s a service, not a loan!”), many are. However, this is another example of using a line of credit as a source of emergency money on a need-to-know basis.

Types of Line of Credit

#1. Personal credit line

This gives you access to unsecured funds that you can borrow, pay back, and then borrow again. A credit history free of defaults, a credit score of 670 or above, and consistent income are all required to open a personal line of credit.

Savings and collateral in the form of stocks or CDs can help, albeit a personal LOC does not require collateral. Personal LOCs are used for a variety of reasons, including crises, weddings, and other events, overdraft protection, travel and entertainment, and to enable folks with intermittent income to smooth out the bumps.

#2. Home Equity line of credit (HELOC)

The most frequent type of secured LOC is a HELOC. The market value of the home minus the amount due, which becomes the foundation for setting the line of credit’s size, secures a HELOC.

Typically, the credit limit is equivalent to 75 per cent or 80 per cent of the home’s market value, minus the mortgage balance outstanding. HELOCs normally have a draw time (usually 10 years) during which the borrower can access funds, repay them, and borrow again.

The amount is due after the draw period, or a loan is extended to pay off the debt over time. HELOCs usually involve closing expenses, which include the cost of an appraisal on the collateral property.

#3. Demand line of credit

This type can be secured or unsecured, although it’s not commonly utilized. The lender can call the amount loaned due at any moment with a demand LOC.

Depending on the terms of the LOC, interest-only or interest plus principal repayment can be made (until the loan is called). At any time, the borrower can spend up to the credit limit.

#4. Security backed line of credit (SBLOC)

This is a unique secured-demand LOC in which the borrower’s securities serve as collateral. An SBLOC typically allows an investor to borrow 50 percent to 95 percent of the value of their assets in their account.

RELATED:  What is a Care Credit? Overview And How Does It Work

SBLOCs are non-purpose loans, which means the borrower is not allowed to buy or sell assets using the funds. Almost any other kind of expense is permissible.

SBLOCs entail monthly interest-only payments until the loan is repaid in full or the brokerage or bank demands payment, which might happen if the investor’s portfolio value falls below the line of credit’s maximum.

#5. Business line of credit

Businesses use them to borrow on an as-needed basis rather than taking out a fixed loan. Before granting a line of credit, the financial institution extending it evaluates the company’s market value, profitability, and risk tolerance.

The LOC may be unsecured or secured, depending on the size of the line of credit requested and the results of the evaluation. As with all LOCs, the interest rate is variable.

Frequently Asked Questions

Is it possible to take out a loan to make a down payment?


Borrowing money to make a down payment is legal as long as you put part of the money you currently have towards the down payment.

What are the dangers of taking out a line of credit?


Personal lines of credit, such as credit cards and other kinds of revolving credit, can harm your credit score if you carry a large balance—usually 30% or more of your established line of credit limit—on them.

What exactly is a credit line, and how does it work?


A line of credit is a type of flexible loan from a financial institution that consists of a set amount of money that you can use as needed and return either immediately or over time. As soon as money is borrowed, interest is imposed on a line of credit.

What are lines of credit used for?


In general, lines of credit aren’t meant to be used to cover one-time purchases like houses or cars—what mortgages and vehicle loans are for—but they can be used to purchase products that a bank might not ordinarily underwrite a loan for.

Are credit cards a line of credit?


Credit cards are unsecured lines of credit, with the credit limit—the maximum amount you can charge on the card—representing the card’s parameters.

Conclusion

A line of credit may be an excellent idea if you need money for a home renovation project, business, college expenditures, or other large expenses – as long as you know you’ll be able to return it.

References

Recommendations

Leave a Reply
You May Also Like