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What Are Lines of Credit & How Do They Work?

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In an ideal world, a personal line of credit is a bank (or credit union) loan that hangs out in the background of your larger financial plan, waiting for action when unexpected or special expenses arise that your budget isn’t prepared to cover.

In many ways, a personal line of credit resembles a credit card:
  • There’s a specific amount you can borrow against (much like the limit on most credit cards)
  • You may use it for any purpose
  • You may pull the trigger as it’s needed
  • And in most cases, as you pay off the balance, you free up the loan amount to borrow against again. (This is the classic definition of “revolving credit.”)

A personal line of credit is an unsecured loan. That is, you’re asking the lender to trust you to make repayment. To land one, then, you’ll need to present a credit score in the upper-good range — 700 or more — accompanied by a history of being punctual about paying debts.

Oftentimes, personal lines of credit fund home remodeling projects, but, to reiterate, the lender isn’t interested in how you plan to use the money, only that you’re an excellent risk to pay it back.

So, got your eye on that once-a-decade cruise? That tired family room needs fresh furniture? Squeezed by medical bills? The kids need help paying for college? You’re paying for a wedding? Your income is irregular — you freelance, work seasonably, or juggle contract jobs — but your bills are steady?

These and countless other situations are prime candidates for personal lines of credit. You borrow against your limit in sums as small or large as you need. And you pay interest (usually a significant number of points lower than any standard-issue credit card) only on the outstanding balance, not the overall loan limit.

Sound good? Eyes wide open, please. Like any form of debt, personal lines of credit carry risks; mismanagement can lead to financial and personal heartache.

For instance, pawn brokers and payday lenders sort of fall into the universe of personal lines of credit — they don’t care how you spend your loan, only that you pay it back, and they’re happy to have your repeated business — but their fees and interest rates can be staggering. Better to stick with reputable financial institutions.

Also, don’t borrow against your loan just because you can. Pay attention to your budget; if your income is steady and reliable, beware the temptation to tap your credit line to pay monthly bills.

You also can apply for a secured line of credit by putting up something of value — jewelry, stock portfolio, gold, your home — and probably wind up with an even-lower interest rate. The danger? Mismanaging the line of credit risks the loss of your property.

You also might consider applying for a credit card with a zero-interest introductory rate — but only if you have a solid strategy to pay it off in the teaser period.

Line of Credit Types

As noted above, lines of credit come in two types: unsecured and secured. The first relies entirely on your perceived ability to make repayment that lenders get by reviewing your credit score, credit history, and provable income. The other backstops the loan with something of equal or greater value like your home or some other form of property.

Personal Line of Credit

Similar to a personal loan or a credit card, an unsecured personal line of credit gets green-lighted based on the applicant’s ability to repay the debt. Your credit score, credit history, and income are key factors.

The amount available to a borrower varies from applicant to applicant — and, of course, the applicant’s perceived need. Unless you have steely self-control, don’t apply for a $250,000 line of credit when $25,000 will do.

Make certain you shop and/or bargain for the best available interest rate. Also, watch out for the impact of tack-on fees, such as an annual ding simply to keep the account open. A sizable annual fee may offset an alluring low interest rate.

Uses for a personal line of credit:
  • Emergency expenses: The roof springs a big leak; your car’s transmission blows up; medical bills.
  • Long-term projects: renovating a kitchen, adding a mother-in-law suite, paying for college or a wedding, restoring that 1957 Corvette.
  • Cash-flow management: bridging the gaps for earners of irregular income.
  • Debt consolidation: grouping credit card and other consumer debt into a single loan.
  • Rare life experiences: the cruise of a decade; playing the great golf courses of Scotland; taking a French cooking school vacation; restoring that 1957 Corvette (but we repeat ourselves).

Home Equity Line of Credit

A home equity line of credit — HELOC — is a loan secured by the equity in your house: that is, your home’s value minus its outstanding mortgage balance.

Rarely can you borrow against all the equity in your home. Instead, lenders apply a formula to the maximum size of a HELOC, expressed as the combined loan-to-value (CLTV) ratio.

Assume you have applied to a lender that offers a maximum CLTV ratio of 80%. You’ve lived there a while and the neighborhood has experienced rising values. Your home is worth $400,000 and you owe $150,000 on the first mortgage. You may qualify to borrow up to $170,000 ($400,000 x 0.80 = $320,000; $320,000 – $150,000 = $170,000).

Again, the lender’s primary concern will involve whether the applicant is a worthy risk; how the money is spent is of next-to-zero consequence … to the lender. You, on the other hand, should have extremely good reason(s) to erode your home equity.

One key use for a HELOC: home renovation projects. Not only will the project add value (thus, equity) and livability to your dwelling, the IRS allows itemizers to deduct some the interest paid on a HELOC (up to $750,000 for combined mortgage debt for married-filing jointly taxpayers).

The uses mentioned above for unsecured lines of credit are also in play. Because you’re putting your house on the line, you’ll likely score a better interest rate — it should be close to first-mortgage refinancing rates — than for an unsecured line of credit.

Business Line of Credit

Not to be confused with a traditional term loan, which provides a single, upfront lump sum that’s repaid over a specific period (or term), a business line of credit works like other lines of credit: Reuse and repay as often as you like, as long as your account is in good standing and you don’t exceed your credit limit.

Limits on business lines of credit tend to be lower than term loans, typically ranging from $1,000 to $250,000. They also tend to be unsecured, which means collateral — inventory, real estate — is not encumbered.

Lenders rely on personal and business tax returns, bank account information, and business financial records, such as profit-and-loss statements and a balance sheet.

Thinking about going the online route? Upside: Internet business lenders often have looser qualifications than traditional lenders. Downside: Credit limits may be lower, interest rates higher.

To qualify, the business will have to have been around for at least six months and be able to demonstrate $25,000 in annual revenue.

In short, if a business can qualify, a business line of credit offers flexibility a traditional term loan cannot.

Uses for Lines of Credit

Did we mention personal lines of credit (a) can be used for almost anything, but (b) failing to repay them on schedule can precipitate lasting financial trouble? Still true.

Home improvement projects are the most common use for personal LOC, but there are other situations where the interest rate and flexible repayment options (keeping in mind the potential, game-shifting annual fees) make lines of credit worth considering.

Some of those options include:
  • Projects with funding challenges: Your daughter’s marriage comes at the same time the roof needs replacing. A line of credit (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 you want to buy a business, or spark growth through advertising, marketing or participating in trade shows.

Worth repeating: As with all cases of borrowing, make sure you have a strategy for repaying the money with interest and fees before you take a loan.

How to Get a Line of Credit

Personal LOCs often come with lower interest rates than credit cards, making them a superior choice for borrowing. They also offer variable access to cash instead of a lump-sum, single-purpose loan. A credit line allows you to borrow in increments, repay it and borrow again as long as the line remains open. Typically, you will be required to pay interest on borrowed balance while the line is open for borrowing, which makes it different from a conventional loan, which is repaid in fixed installments.

If you conclude that a line of credit best meets your needs, prepare your case before approaching a lender:
  • How do I apply for a credit line? Personal lines of credit are unsecured, which means you don’t need to offer collateral to protect the lender if you default. That makes it different from home equity lines of credit (HELOCs), which are secured by the equity in your home. Since risk is a key facet of lending, interest on a LOC almost certainly will be higher than on a HELOC. Therefore, it’s crucial to convince the lender you are a good risk. Never having defaulted on a loan, or not having defaulted in years, helps. Having a high credit score also demonstrates creditworthiness. You should also let the lender know about all sources of income and your savings, which can help establish you as a good risk.
  • How large a credit line should you request? The larger your credit line, the greater risk you pose to the lender. You should probably hold your requested amount to what you realistically might need to borrow, keeping in mind your income stream and ability to repay the borrowed money. Lenders will evaluate your creditworthiness using several metrics including your credit score, you loan repayment history, any business risks you might have, and your income. Each influences how large a credit line is offered.
  • What credit scores and collateral might be required? Since personal LOCs often are made based on income and credit history, having a strong credit score is crucial. Credit scores, assigned and updated by the nation’s three large credit-rating agencies, range from 300 to 850.

Problems with Personal Lines of Credit

Though there are many attractive sides to personal lines of credit, as with every loan, there are trouble spots to consider. The top two: getting approved and the interest rate banks will charge.

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

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

Because there is no collateral defending the lender against the loan going bad, the interest rates on a line of credit are higher than mortgage or car loans. This does not mean you can’t score an attractive rate. In late 2020, many online lenders were advertising rates below 6%. Among all lenders, the average rate was about 11.5%, but your mileage may vary, depending on your credit and income situation.

Another trouble spot: Unlike typical term loans, rate on personal LOCs are variable, making them subject to the whims of the marketplace. They can change year-by-year, depending on the terms of the loan agreement.

Also, be aware that a line of credit can influence 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 available, for example — your credit usage will hurt your credit score. Likewise, taking below 30% of your draw is considered good use, boosting your score.

At the risk of repeating ourselves: Study the proposed LOC maintenance fees (usually annual, sometimes monthly). Understand the repayment schedule. Read the contract closely, making certain you grasp all the payment terms before agreeing to a LOC.

Are there prepayment penalties? You need to know.

Secured vs. Unsecured Credit Lines

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. Because they are defended against loss, creditors usually offer lower interest rates, higher spending limits, and better terms on secured lines of credit.

HELOCs are a widely used form of secured credit lines. HELOCs use equity in real estate as collateral and are really second mortgages attached to credit lines. For that reason, applying for a HELOC is very similar to applying for a mortgage. Lenders will appraise your home, check your credit score and income, and ask about your other investments and debts.

The amount of equity you have in your home — essentially the dwelling’s value minus what you owe on it — will limit the size of your credit line. Because HELOCs are secured loans, a lender has collateral if you default and typically will offer interest rates far lower than on comparable unsecured personal LOCs.

Unsecured lines of credit require no collateral. A creditor is accepting the borrower’s word that (s)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. An enduring relationship with the bank or credit union doesn’t hurt.

Credit cards are the most common form of unsecured lines of credit. Personal LOCs often come with lower interest rates than credit cards, tand the difference might be considerable. Personal LOC lenders can offer advantages, such as flexible repayment schedules, that most credit cards don’t. For business owners, LOCs offer a solution for contractors who won’t accept credit cards. Like credit cards, LOCs can be useful for dealing with unexpected expenses or to make payments when business income is delayed.

If you don’t repay an unsecured debt, the lender may hire a debt collector or sue to try to collect.

Revolving vs. Non-revolving Lines of Credit

Open-end credit is better known as revolving credit. Credit cards are the most used form of revolving credit, requiring the borrower to pay at least a minimum amount of the total owed each month.

Generally, a loan that allows the consumer to borrow portions of the credit limit, charges interest only on the outstanding balance, and frees up credit as the balance is paid down, amounts to revolving/open-end credit.

Home equity lines of credit (HELOCs) are revolving 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 still owed — our friend the combined loan-to-value ratio.

Here’s another example: If your home is worth $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, equaling $30,000.

Avoid the temptation to sample lenders who will go above 80% CLVR, or risk triggering private mortgage insurance, which is sure to take an appreciable bite from your budget.

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 you borrow. 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. Used for home improvements (renovated kitchen and/or baths, room additions) HELOCs can be tax-deductible for filers who itemize.

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

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

Other Revolving Credit Sources

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

Overdraft protection on checking accounts is considered a revolving 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” the difference to make the check good. The customer pays interest for that loan and must repay the balance in a specific time frame.

Revolving 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 revolving/open-end source of credit is travel and entertainment cards, or T&E cards. These 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.

Consumers may use T&E cards to charge as much as they want during the month, but the issuer requires you to pay the balance in full at the end of the month. If payment is not received on time, late fees are applied.

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

Similarities and Differences with Other Loans

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

For example, a personal LOC 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 an LOC is typically 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 an LOC, while money in a personal loan is disbursed all at once. The interest rate on a LOC is variable; you pay it only on the portion of funds you use. A personal loan usually 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 for 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 favorable 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 both involve a lender. A LOC is superior in every way imaginable. You can receive a far bigger loan ($3,000-$100,000 for LOC vs. $400 for average payday loan); you pay far lower interest rates (6%-14% vs. 399%-521%); and repayment terms are much easier (10 years vs. two weeks).

Be sure to compare LOCs with other revolving/open-end credit options before deciding which works best for you.

If you’re looking for a bad-credit (subprime) loan — that is, a loan you can qualify for with a less than ideal credit score — options are scarce.

Most online lenders (Prosper, SoFi, LightStream, Marcus, Upstart, Best Egg, and so on) require a credit score in the mid-to-high 600s. You might be able to qualify for a personal loan from a credit union if you have a long-standing relationship. If all else fails, get a co-signer with better credit to vouch for you.

As ever, be careful out there.

About The Author

Bill Fay

Bill “No Pay” Fay has lived a meager financial existence his entire life. He started writing/bragging about it in 2012, helping birth Debt.org into existence as the site’s original “Frugal Man.” Prior to that, he spent more than 30 years covering the high finance world of college and professional sports for major publications, including the Associated Press, New York Times and Sports Illustrated. His interest in sports has waned some, but he is as passionate as ever about not reaching for his wallet. Bill can be reached at [email protected].

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