August 5, 2024

What is a Line of Credit? Types and When to Use Them

Sometimes you need extra funds for a major purchase or project — but predicting the exact cost upfront feels like trying to hit a bullseye blindfolded.

Lines of credit offer a versatile solution, allowing you to borrow money as needed, up to a preset limit. But before applying for one, it’s critical to understand how they work, what they’re best for, and the potential risks involved.

So, what’s a line of credit? And how does it actually work? Here’s everything you need to know.

What is a line of credit?

A line of credit is a flexible borrowing account that lets you access funds up to a predetermined limit. Unlike a traditional loan, where you receive a lump sum upfront and start accruing interest immediately, with a line of credit, you only borrow what you need. The lender only charges interest on the amount you actually use.

Think of a line of credit like a financial safety net. It’s there when you need it, but you’re not obligated to use it. This makes a line of credit a flexible tool for handling expenses that are difficult to predict or that may arise unexpectedly.

People turn to lines of credit for a variety of reasons. You can use them to consolidate high-interest debt, cover unexpected medical bills, or provide a financial cushion during career transitions. Entrepreneurs often use them to manage cash flow fluctuations and capitalize on business opportunities, and students might have them to pay for tuition and other needs. You really can use one for anything, but be careful not to overuse it or take out more money than you need.

4 types of credit lines

Not all lines of credit are created equal. Depending on your financial situation and needs, certain types are more suitable than others.

Here are the most common types of lines of credit and when you might use each one:

1. Personal line of credit

This type of credit is based on your personal creditworthiness. It’s a versatile option for covering a wide array of expenses. Emergency expenses, debt consolidation, and funding long-term projects are some common use cases for these lines of credit. For example, you might turn to one if you’re planning a home renovation but aren’t sure of the final cost yet.

A personal line of credit allows you to borrow as needed, making it a better option than credit cards because you don’t have to carry a balance. Plus, it often has lower interest rates, so they’re a smarter choice for major expenses.

2. Business line of credit

This option is tailored for companies and entrepreneurs who need flexible access to funds. Business lines of credit help with managing cash flow, covering operational expenses, and taking advantage of growth opportunities. A seasonal business, for instance, might use a line of credit to stock up on inventory before their busy season, then pay it off when their revenue is higher.

When considering applications, banks look at business financial statements and various metrics. This can sometimes make it easier for businesses to qualify, compared to personal lines of credit.

3. Home equity line of credit (HELOC)

With a HELOC, you borrow against the equity in your home. HELOCs are often used for major expenses like home improvements, college tuition, or debt consolidation.

Two important terms to understand with HELOCs are equity and the Combined Loan-to-Value (CLTV) ratio. Equity is the difference between your home’s value and what you owe on your mortgage, while the CLTV ratio is the total amount you’ve borrowed (including your mortgage and HELOC) divided by your home’s value. Lenders use these figures to determine how much you can borrow through the line of credit.

HELOCs also come with a potential tax benefit: You may be able to deduct some HELOC interest on your taxes if you do use the money for home improvements.

4. Secured line of credit

These lines of credit are backed by an asset, like a car or savings account. They can be a good option if you’re having trouble qualifying for an unsecured line of credit or want to get a better rate. For example, you might use your car as collateral to secure a personal line of credit. The catch is that the lender can seize your car if you fail to pay.

Because the lender has your asset as security, it typically offers lower interest rates compared to unsecured lines of credit. But there’s more risk involved, so proceed with caution.

Pros and cons of lines of credit

Like any financial tool, lines of credit come with their own set of advantages and drawbacks. Understanding them can help you decide if a line of credit is the right choice for your financial needs.

Pros of lines of credit

Quick access to cash. When you need money, a line of credit gives you immediate access to funds. There’s no need to apply for a loan each time you need to borrow.
Flexibility. Lines of credit shine when it comes to financing projects with variable costs. Whether you’re renovating your home or starting a new business, you can borrow exactly what you need, when you need it, instead of taking out a set loan.
Limited interest charges. Unlike traditional loans where you pay interest on the full borrowed amount, you only pay interest on the money you actually use.

Cons of lines of credit

Higher interest rates. While lines of credit generally have lower interest rates than credit cards, they could have higher rates than traditional loans. The exact numbers depend on factors like your credit score and whether the line is secured or unsecured.
Stricter requirements. Lenders often have tougher standards for approving lines of credit compared to traditional loans. You may need a higher credit score or more substantial income to qualify. Putting up collateral for a secured line of credit can make qualifying easier, but it’s a riskier process.
Complex fees. Lines of credit can come with extra fees that might be more complicated than traditional loan fees. These may include annual fees, draw fees, and inactivity fees.

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FAQs

What’s the difference between a line of credit and a credit card?

While both offer flexible borrowing, lines of credit typically have lower interest rates and higher limits than credit cards. They’re often used for larger expenses, while credit cards are better for everyday purchases. Lines of credit also tend to have stricter approval processes.

How do I qualify for a line of credit?

Qualifying for a line of credit involves a review of your financial health. Lenders typically look at your credit score, income, and existing debts. A good credit score may be required, especially for unsecured lines of credit. And for secured lines like HELOCs, you’ll need sufficient equity in your home.

How does a line of credit affect my credit score?

Applying for a line of credit may require a hard credit check, which can cause a dip in your score. And once you have the line, keeping your credit utilization low (under 30%) and making timely payments can positively impact your score. Missing payments or maxing out can hurt your score significantly, so be careful.

Please note, the material collected in this post is for informational purposes only and is not intended to be relied upon as or construed as advice regarding any specific circumstances. Nor is it an endorsement of any organization or services.

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