What is a Line of Credit?
A line of credit, or credit line, is a specialized financing option that is part credit card and part loan. If you take out a line of credit for your business, you get access to a lump sum, like you would with a traditional loan, but you withdraw from that sum and pay it down each month like a credit card. Withdrawals and payments can vary month-to-month, and you only ever pay interest on the funds you withdraw. Individuals and business owners alike find credit lines useful because they help smooth over unstable finances. For instance, if your business is seasonal, you can use the line of credit to cover slow months and then pay it down when business picks up. Also, it’s handy to have access to funds in case there’s ever an emergency. Finally, as a side note, interest paid on lines of credit used for investments is, in some cases, tax-deductible.
Business Line of Credit
Home Equity Line of Credit
Personal Line of Credit
How Does it Work?
If you get approved for a line of credit, you can immediately start withdrawing funds. Like we said above, you only ever pay interest on the funds you actually withdraw and use, and you’re not ever required to withdraw the full amount. Like a credit card, you are expected to make minimum monthly payments. Like a loan, however, at the end of the term of your line of credit, you will need to repay whatever is missing from the lump sum full, in addition to the interest, which is known as a balloon payment. If you’re approaching your balloon payment and don’t think you can pay, you can always refinance your credit line. There are sometimes fees associated with opening a line of credit. Most lenders include an annual fee in their agreements. Some lenders also include a maintenance fee to account for unused funds. When you first get your line of credit, an administrative fee, usually around a few hundred dollars, will be charged as well. It’s also worth mentioning that insurance can be purchased to protect an estate in the event of sickness or death from having to continue paying down a standing line of credit. Although lines of credit can be a great asset for an individual or a business, there is a danger in spending the money too freely. There are stories of people using their line of credit for personal things they didn’t necessarily need and winding up in debt. Lines of credit affect your credit score, so it’s important to be judicious when spending your pre-approved funds.
Interest rates for lines of credit vary with an applicant’s revenue/income and credit score, but generally are lower than those you would find when applying for a credit card. Interest rates on credit lines are calculated by starting with the prime rate of the bank or lender (the lowest possible rate at which money is lent) and adding a margin. Since the prime rates of lending institutions change over time, interest rates on credit lines are variable, fluctuating with the market. Secured lines of credit, those where the applicant has put up some kind of property or holding as collateral, have lower interest rates than unsecured lines of credit as they are less risky for lending institutions.
Credit requirements differ greatly depending on the type of line of credit you’re looking to get. Personal, unsecured lines of credit, the kind you might use to fund a wedding, typically will require the applicant to have a strong credit score, usually around 680. For unsecured business lines of credit, lenders will typically look at your revenues and profits, how long you’ve been in business, your financial ratio (such as debt to equity), and, in some cases, the personal credit of the owner or owners of the business. Secured lines of credit will still take your credit score into account when determining a rate, but because you’ve put up some form of collateral as a guarantee, the rates will almost always be lower.
Secured vs Unsecured
Secured lines of credit are guaranteed by collateral. This secures the credit line for the lender, making it far less risky, which means a better interest rate for the applicant. An example of a popular secured line of credit is a Home Equity Line of Credit (HELOC) in which an applicant’s home is put up as collateral. Unsecured lines of credit are unsecured by any collateral, are riskier for lenders, and thus have higher interest rates as a result.
For Bad Credit
Having bad credit will put you in a tough spot if you’re looking for a line of credit, as there is usually little sympathy from lenders for those in this tough position. Some institutions, such as credit unions, are designed to help people with bad credit, as they are cooperatively owned and community-oriented, and therefore might look past bad credit if the applicant’s character and pledge to repay are trustworthy. Another option if you have bad credit is to use your home as collateral. A HELOC (home equity line of credit) is a line of credit secured by your home, a piece of collateral so secure many lenders will look past bad credit scores.
No Credit Check
There are many lenders who offer personal lines of credit with no credit check required. Unfortunately, most people applying for these have few options because of their bad credit, a lot of lenders take advantage of that with high interest rate credit lines filled with fees and harsh repayment terms. This isn’t to say there isn’t a body of responsible lenders and third-party brokers that have your best interests at heart, but you should be careful to distinguish between the two when searching out your ideal credit line.
Line of Credit vs Loan
A line of credit is, in many ways, a mix of a loan and a credit card. First, both credit lines and loans require acceptable credit to be granted. Both charge interest on borrowed funds, and both affect the recipient’s credit score. Finally, both can be secured or unsecured. Lines of credit are different from loans in that, unlike loans, there are typically no restrictions on how you spend your funds. Another difference is that credit lines can be paid down like a credit card, where you meet a minimum monthly payment but otherwise can pay the principal whenever you are able, whereas loans almost always have rigid repayment schedules that have to be met.
Line of Credit vs Credit Card
A line of credit is like a credit card in several ways, mostly procedural. With both, an applicant’s creditworthiness is a deciding factor on the limit and interest rate. Both allow the recipient to withdraw funds, up to a pre-established limit, and pay down balances when they can. Neither charge interest on anything other than the funds that have been used, and both affect your credit score. A key difference between credit cards and lines of credit is that a line of credit can be secured with collateral, functioning in this way more similarly to a loan than a credit card. A second key difference is that interest rates on credit lines are variable, changing with the market, where interest rates on credit cards are typically stable.
Advantages and Disadvantages
A line of credit has many advantages over other traditional forms of lending for people in need of a flexible, low-cost, and long-term funding solution. If you’re looking to ameliorate specific financial problems, such as funding one-off projects or life events, financing investments, or stabilizing irregular finances, a line of credit is the perfect financing option. This isn’t to say there aren’t disadvantages as well. As mentioned above, the interest rates on lines of credit are variable, fluctuating with the market. This isn’t purely negative, as rates can go down as well as up, but it does add an element of unpredictability to your financing. Also, when paying down a line of credit, you’re only ever required to make minimum payments on the interest you accrue. This means that, when the loan is up, you are expected to pay back the entire balance in full in what is known as a balloon payment. There are stories all over the web of balloon payments ruining peoples’ finances because they didn’t plan well or couldn’t refinance their credit line. If you take out a line of credit, be sure to plan accordingly with the balloon payment in mind. Finally, if you have a secured line of credit and fail to make payments, whatever property has been leveraged as collateral will be seized by the lender.