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Lines of Credit – How It Works, Its Types, and More

Several borrowing options are available when people need money. While credit cards and personal loans are widely renowned, broader options like lines of credit are less known. A line of credit is a flexible, revolving loan from a financial institution that gives one access to a store of money until a certain limit. One can withdraw from this line until they reach the maximum limit.

What is a line of credit?

Lines of Credit – How It Works, Its Types, and More

Essentially, a line of credit is a flexible loan from any financial institution, such as a bank or a credit union.  This offers a fixed amount of money that borrowers can access and use as needed. This money can be paid back instantly or over time, and an interest charge is associated with it.

How does a line of credit work?
When people need money, they generally head to the bank to ask for a personal loan or a line of credit. With a personal loan, one is handed a lump sum of money, with interest payments starting almost immediately. With a line of credit, however, an individual gets access to a set amount of money that can be borrowed whenever they want. Until a withdrawal is made from this LOC, no interest is incurred on the money. Like a personal loan, an LOC can be secured or unsecured.

  • Unsecured line of credit
    Most personal LOCs tend to be unsecured. This means that no collateral is promised to the lender at the time of the transaction. A credit card is an example of an unsecured line of credit. Typically, these can be difficult to attain as they require a higher credit score.
  • Secured line of credit
    A secured line of credit may be more attractive for those who need a higher maximum credit limit and lower interest rates.  This is possible because the lender can recoup their funds in the event of non-payment.

Types of lines of credit
LOCs can further be broken down by type. These are as follows:

  • Personal Line of Credit (LOC)
    Personal lines of credit give one access to unsecured funds that can be borrowed and repaid several times. To qualify for these loans, one must have a reliable income, a credit history with no defaults, and a credit score of 670 or higher. These are best used during emergencies, weddings, overdraft protection, travel, etc.
  • Home Equity Line of Credit (HELOC)
    HELOC is the most popular type of secured LOC that draws value from one’s home. The total value of credit is determined by subtracting the amount owed from the total market value of the home. This generally ends up being around 75% to 80% of the market value of the home (minus the mortgage balance). These lines of credit generally have a draw period (around 10 years) during which one can borrow, repay, and borrow again.
  • Business line of credit
    Often, businesses also need access to a little extra money. This is available using a business line of credit. Here, the lender offers credit based on the company’s market value, profitability, and risks taken by them. Depending on the overall credit amounts and risks involved, these can be secured.
  • Securities-Backed Line of Credit (SBLOC)
    In some cases, a special SBLOC may be needed.  This is a secured line of credit with collateral from the borrower’s securities. Here, the investor can borrow between 50% and 95% of the value of the assets in their account. It is important to note that this money cannot be utilized to buy or trade more securities, but most other expenses are allowed.

    With SBLOCs, the borrower is expected to make monthly, interest-only payments until the amount is paid in full or until the lender demands payments (if the portfolio falls below the level of the LOC).

Benefits of lines of credit
There are several advantages to having a line of credit. These are as follows:

  • Interest payments
    With LOCs, interest is only paid on the borrowed money instead of the overall loan amount.
  • Flexibility
    Unlike personal loans, LOCs offer a long draw period, spanning several years, giving one access to extra money whenever needed.
  • Replenishing balance
    Once the money is paid back within the draw period, it becomes available to borrow again, essentially acting like a replenishing loan coffer.

Tips to manage an LOC
Here are a few tips to manage an LOC:

  • Ask the lender representative any questions before signing up to open a line of credit.  This will help one better understand the agreement’s nitty-gritty.
  • Before opening a line of credit, one must be properly informed of the maximum withdrawal limits to avoid overextending their account and paying penalties.
  • Avoid rash borrowing from an LOC, as the costs can quickly increase.
  • Since LOCs have variable interest rates and fees, one must keep a close eye on these details.
  • Monitor the LOC frequently. Tracking credit utilization can help one stay within one’s budget and maintain one’s credit scores.
  • Avoid taking fresh loans before clearing off the older ones.
  • Speak to a financial advisor for better insights on handling multiple lines of credit.
Disclaimer:
The information available on this website is a compilation of research, available data, expert advice, and statistics. However, the information in the articles may vary depending on what specific individuals or financial institutions will have to offer. The information on the website may not remain relevant due to changing financial scenarios; and so, we would like to inform readers that we are not accountable for varying opinions or inaccuracies. The ideas and suggestions covered on the website are solely those of the website teams, and it is recommended that advice from a financial professional be considered before making any decisions.