What Is A Personal Line Of Credit?

    The advantages and disadvantages of personal creditA line of credit is any credit source extended to a business, government or individual by a bank or lending institution. A line of credit establishes a maximum loan balance — the credit limit — that the customer is permitted to borrow against.

    In a personal line of credit, an individual can draw upon the credit any time to pay a bill or make a purchase as long as the credit limit is not exceeded.

    A business line of credit works the same way. The business can use the money any time to expand or take advantage of opportunities as long as it doesn’t exceed its credit limit.

    The advantage a line of credit has over a regular loan is that the line of credit does not have to be used for a specific purchase and no interest is charged on the unused amount.

    Uses For Lines Of Credit

    Individuals who receive a personal line of credit (LOC) quickly discover that it resembles credit cards. It can be used for almost anything, but therein lies a warning: Be careful that you don’t spend more than you can repay.

    Home improvement projects are the most common use for personal LOC, but there are other situations where the interest rate and flexible repayment options make lines of credit worth considering.

    Some those options include:
    • Projects with funding challenges. Your daughter’s marriage comes at the same time the roof needs replacing. A LOC could meet the challenge of paying for both.
    • People with irregular incomes. You are self-employed or work on commission and the next paycheck isn’t coming for another month. Drawing from a line of credit allows you to pay your regular monthly bills until the next paycheck arrives.
    • Emergency situations. Tax bill comes the same time the credit card bills are due along with college tuition for your child. Consolidate your debt with a line of credit.
    • Overdraft protection. If you are a frequent check writer with unstable income, a LOC can serve as a backup when you need overdraft protection.
    • Business opportunity. A line of credit serves as collateral if want to buy a business, or spark growth through advertising, marketing or participating in tradeshows.

    Just make sure when you take on a line of credit it is needed and affordable enough to be easily repaid. Don’t take on unnecessary debt.

    Problems With Personal Lines Of Credit

    Though there are many attractive sides to personal lines of credit (LOC), as with every loan, there are some trouble spots to consider.

    The two biggest ones are getting approved and the interest rate banks will charge.

    Lines of credit are unsecured loans, and that means the bank is taking a huge risk. The bank has to be certain the borrower has a credit history that indicates he can pay back the loan. Therefore, expect everything in the customer’s credit report to be scrutinized closely.

    If you have a poor credit score or history, it will be very difficult for a lending institution to extend you a LOC.

    The interest rates on a line of credit are higher than mortgage or car loans because there is no collateral. The average rate in 2015 range from 9% to 15%, but could be higher if the borrower’s credit score is shaky.

    Another problem is that the interest rates are variable, making them subject to the whims of the marketplace. They can change from year-to-year, depending on the terms of the loan agreement.

    Also, be aware that a line of credit can hurt or help your credit score, depending on how you use it. If you draw a high percentage of the amount borrowed – taking $9,000 of the $10,000 you borrowed, for example – it will hurt your credit score. Likewise, take less than 30% of your draw is considered good use and improves your credit score.

    The last thing to consider with a LOC is the maintenance fees (usually annual, sometimes monthly) and repayment schedule. Read the contract closely and be sure you understand all the payment terms before agreeing to a LOC. Find out if there are prepayment penalties.

    Secured Lines Of Credit vs. Unsecured Lines Of Credit

    A secured credit line is one in which the borrower uses an asset, usually a car or home, as collateral to secure the loan. The lender can seize the asset if the borrower doesn’t repay the debt according to the terms. Creditors usually offer lower interest rates, higher spending limits and better terms on secured lines of credit.

    Unsecured lines of credit require no collateral. A creditor is accepting the borrower’s word that he will repay the debt. It usually is difficult to get an unsecured LOC approved unless you are a well-established business or an individual with an excellent credit rating.

    Credit cards are the most common form of unsecured lines of credit. If you don’t repay an unsecured debt, the lender may hire a debt collector or sue to try and collect money.

    Open-End vs. Closed-End Lines of Credit

    Open-end credit is also known as revolving credit. Credit cards are the most used form and they require the borrower to pay at least a minimum amount of the total owed each month, though it is hoped they will pay the entire amount.

    Home equity lines of credit (HELOCs) are open-end lines of credit. The amount you can borrow is based on a percentage of your home’s appraised value (usually 70-80%), minus the amount that you still owe.

    For example, if the present value of your home is $200,000, multiply that amount by 75%, which comes to $150,000. If you bought the house for $160,000 and your equity in the home is $40,000, you still owe $120,000 to your mortgage lender. Therefore, your potential line of credit will be $150,000 minus $120,000, which equals $30,000.

    To determine your actual credit limit, a lender also will consider your ability to repay the loan by examining your credit history, income and other financial obligations.

    Many home equity lines of credit set a time limit during which you can borrow money, and it’s usually 10 years. Once approved for a HELOC, you can borrow up to your credit limit whenever you want during that period. The interest rate will vary, based on a publicly available index, such as the prime rate or a U.S. Treasury bill rate.

    You will pay interest only on the amount of money you actually borrow and as long as you make a minimum monthly payment you can pay back as much or as little as you want every month until the end of loan period, when the entire principal amount is due.

    Because a HELOC is secured by your home, the interest rate can be lower than for other lines of credit. HELOCs can be tax-deductible.

    However, you may have to pay certain additional costs, including the price of a home appraisal, closing costs (possibly including points, title fees and taxes) and maintenance and/or transaction fees.

    Closed-end credit provides a fixed amount of money to finance a specific purpose and period of time. The loan may require periodic principal and interest payments, or payment of the entire principal at the end of the loan term.

    Examples of closed-end credit are: most real-estate loans; car loans; appliance loans; and payday loans (small, short-term loans secured against a customer’s next wages).

    Other Open-End Credit Sources

    The market for open-end credit is dominated by credit cards and lines of credit, but there are some lesser-known avenues available for those willing to do their research.

    Overdraft protection on checking accounts is considered an open-end source of credit. When a customer writes a check and doesn’t have enough money in the account to cover it, the bank essentially “loans” him the difference to make the check good. The customer pays interest for that loan and must repay the balance in a specific time frame.

    Open-end personal checking lines also are available in some banks and credit unions. The bank or credit union establishes a credit limit and deposits that in the bank for you to write check against rather than you depositing money into an account and then writing checks against that amount.

    Another open-end source of credit is travel and entertainment cards, also known as T&E cards. They are most popular with people who travel frequently and use them to make dinner, golf, tennis or spa reservations and to access airport lounges and receive car rental discounts.

    T&E card customers can use them to charge as much as you want during the month, but they require that you pay the balance in full at the end of the month. Late fees are applied to the account, if payment is not received on time.

    Diners Club and Carte Blanche are the two most popular forms of travel and entertainment cards.

    Similarities And Differences With Other Loan

    A personal line of credit (LOC) has many similarities to credit cards, personal loans, a home equity line of credit (HELOC) and payday loans, but enough differences to make it a distinctive form of borrowing worth investigating when you need money quickly.

    For example, it functions just like a credit card in that you can use it for almost anything, get a monthly statement showing your expenses, interest charges, amount owed and minimum payment due, but is different in that the interest rate for LOC is typically much lower and the credit limit is much higher.

    There are many differences between a line of credit and personal loans, the primary one being that money is disbursed on a draw as needed in a LOC while money in a personal loan is disbursed all at once. The interest rate on a LOC is variable and you only pay it on the portion of funds you use. A personal loan carries a fixed interest rate and monthly payments are made on the balance owed.

    A LOC is first cousin to a HELOC in that both extend lines of credit to use as needed. However, you don’t have to put your home up as collateral with a LOC. A LOC is unsecured and thus far more secure for the borrower. The added risk to the bank could mean higher interest rates charged for the LOC, but still, they can’t take your home.

    The only similarity between a LOC and a payday loan is that in both cases you receive money from a lender. However, a LOC is superior in every way imaginable. You can receive a far higher amount of money ($3,000-$100,000 for LOC vs. $400 for average payday loan); you pay far less interest rates (8-14% vs. 391-521%) and repayment terms are much easier (10 years vs. 2 weeks).

    Be sure you understand the nuances between LOC and other forms of open-end credit and always compare and contrast them before choosing.

    Al Krulick

    Al is an award-winning journalist with dozens of years of writing experience. He served as a drama critic, high school teacher, arts administrator, theatrical producer and director. He also dabbled in politics, running twice for a seat on the U.S. House of Representatives for Florida. Al is a Certified Debt Specialist with the International Association of Professional Debt Arbitrators and specializes in real estate, credit and bankruptcy advice.

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