What Is a Personal Line of Credit & How Do They Work?

    The advantages and disadvantages of personal credit

    A personal line of credit is a bank loan that closely resembles a credit card in the sense that you have a specific loan amount of money (comparable to a credit card limit) that you can use for any purpose, as needed.

    The personal line of credit is unsecured, so to get one, you probably will need a credit score at or above 700 and have a good history of repaying debts in a timely fashion. Personal lines of credit are used mostly for home remodeling projects, but could help pay for a great vacation, medical bills, buying new furniture or helping a child pay for college.

    Again, you can spend the money for whatever you want, in whatever small or large sums you wish, as long as you don’t exceed the approved line of credit.

    As with other forms of credit, it has risks and can end up costing a good deal if not handled correctly. 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

    Personal lines of credit can be used for almost anything, but failing to repay them on schedule can lead to big financial problems.

    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 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 tradeshows.

    As with all cases of borrowing, make sure you have a strategy for repaying the money with interest 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 much better 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 to 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 will almost certainly be higher than on a HELOC. Therefore, it’s crucial to convince the lender that 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 and will limit how large a line they offer.
    • 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. The higher your score, the better your risk profile. Typically, you will need a prime score, no lower than 680, but each lender has its own standards. Most personal LOCs don’t require collateral, but you might be able to improve your odds of qualifying and lower your rate if you have an investment, such as a CD or savings account, with the lender that can partially secure you credit line.

    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 will 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 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. 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 want to 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 will typically offer interest rates that are far lower than on comparable unsecured personal LOCs.

    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. Personal LOCs often come with lower interest rates than credit cards, though the difference might be considerable. They can offer advantages, like flexible repayment schedules, that credit cards don’t. For business owners, they offer a solution for contractors who won’t accept credit cards. Like credit cards, they 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 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 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, 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 you 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. 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 Loans

    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 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 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 in 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 less interest rates (8%-14% vs. 399%-521%) and repayment terms are much easier (10 years vs. two weeks).

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

    If you’re looking for a bad credit loan, or a loan that you can qualify for with a less than ideal credit score, there aren’t many options available to you. Most online lenders like Prosper and SoFi 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.

    Bill Fay

    Bill “No Pay” Fay has lived a meager financial existence his entire life. He started writing/bragging about it seven years ago, helping birth Debt.org into existence as the site’s original “Frugal Man.” Prior to that, he spent more than 30 years covering college and professional sports, which are the fantasy worlds of finance. His work has been published by the Associated Press, New York Times, Washington Post, Chicago Tribune, Sports Illustrated and Sporting News, among others. His interest in sports has waned some, but his interest in never reaching for his wallet is as passionate as ever. Bill can be reached at bfay@debt.org.

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