Line of Credit (LOC) Definition, Types, and Examples

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Line of Credit (LOC) Definition, Types, and Examples

What Is a Line of Credit (LOC)?

A line of credit (LOC) is a predetermined borrowing limit that may be used at any time. The borrower may withdraw funds as required until the limit is met. In the event of an open line of credit, money may be borrowed again as it is returned.

An LOC is a contract between a financial institution (often a bank) and a client that specifies the maximum loan amount that the customer may borrow. The borrower may withdraw money from the LOC at any moment as long as they do not exceed the agreement’s maximum amount (or credit limit).

Key Takeaways

  • A line of credit (LOC) is a predetermined borrowing limit that a borrower may use at any moment the line of credit is open.
  • Personal, commercial, and home equity credit lines are examples of credit lines.
  • The major benefit of a LOC is its inherent flexibility.
  • High interest rates, late payment penalties, and the possibility of overspending are all possible drawbacks.

How Line of Credit Works

Understanding Credit Lines

All LOCs have a fixed amount of money that may be borrowed, paid back, and borrowed again. The lender determines the amount of interest, the size of installments, and other conditions. Some LOCs provide check writing (drafts), while others incorporate a credit or debit card. A LOC can be secured (backed by collateral) or unsecured, with unsecured LOCs typically carrying higher interest rates.

The major benefit of a LOC is its inherent flexibility. Borrowers may request a certain amount, but they are not required to utilize it all. Rather, they can tailor their LOC spending to their needs and pay interest only on the amount drawn, not on the entire credit line. Borrowers can also change their repayment amounts as needed based on their budget or cash flow. They may return the full outstanding debt at once, for example, or only the minimum monthly installments.

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Unsecured vs. Secured LOCs

The majority of LOCs are unsecured loans. This indicates that the borrower does not guarantee the lenderany security to back the LOC. A significant exception is a home equity line of credit (HELOC), which is secured by the borrower’s home equity. Secured LOCs are appealing to lenders because they give a mechanism to reclaim the borrowed monies in the case of nonpayment. 1

Secured LOCs are appealing to individuals and company owners because they often have a greater maximum credit limit and much lower interest rates than unsecured LOCs. Unsecured LOCs are considerably more harder to get and often need a better credit score or rating. Lenders try to offset the additional risk by restricting the amount of money that may be borrowed and charging higher interest rates. That is one of the reasons why credit card annual percentage rates (APR) are so high.

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Credit cardsare technically unsecured LOCs, with the credit limit—how much you may charge on the card—representing its limitations. However, when you create the card account, you do not commit any assets. If you start skipping payments, there’s nothing that the credit cardissuercan confiscate in recompense.

A LOC may have a significant influence on your credit score. In general, if you borrow more than 30% of your available credit, your credit score will suffer. 2

Revolving vs. Non-Revolving Lines of Credit

An LOC is often seen as a revolving account, sometimes known as an open-end credit account. Borrowers can spend the money, repay it, and spend it again in a virtually never-ending, revolving cycle under this arrangement. LOCs and credit cards are revolving accounts, as opposed to installment loans like mortgages and vehicle loans.

Consumers who take out installment loans borrow a specific amount of money and repay it in equal monthly installments until the loan is paid off. Consumers who have paid off an installment loan cannot spend the money again unless they qualify for a new loan.

Non-revolving credit has the same characteristics as revolving credit (or a revolving LOC).A credit limit is created, money may be utilized for a variety of activities, interest is levied routinely, and payments may be made at any time. There is one significant exception: the available credit pool does not refill once payments are made. When you fully repay the LOC, the account is closed and cannot be used again.

Personal LOCs, for example, are occasionally issued by banks in the form of an overdraft protection plan. A banking client may sign up for an overdraft protection plan that is tied to their checking account. If the consumer goes above the amount available in checking, the overdraft prevents a check from being bounced or a transaction from being refused. An overdraft, like any LOC, must be repaid with interest.

Types of Lines of Credit

LOCs occur in a number of forms, with each falling into one of two categories: secured or unsecured. Aside from that, each form of LOC has its own set of properties.

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Personal Line of Credit

This gives you access to unsecured cash that you may borrow, repay, and borrow again. A personal LOC typically needs a credit history with no defaults, a credit score of 670 or above, and consistent income. Savings and collateral in the form of stocks or certificates of deposit (CDs) are advantageous, while security is not necessary for a personal LOC. Personal LOCs are used for emergencies, weddings and other events, overdraft protection, travel and entertainment, and to help smooth out bumps for persons with unpredictable income.

Home Equity Line of Credit (HELOC)

The most frequent kind of secured LOC is a HELOC. The market value of the property less the amount due secures a HELOC, which serves as the foundation for establishing the size of the LOC. Typically, the credit limit is set at 75% or 80% of the home’s market value, less the mortgage debt.

HELOCs sometimes have a draw term (typically ten years) during which the borrower may access available funds, repay them, and borrow again. The balance is due after the draw period, or a loan is extended to pay off the balance over time. 3 HELOCs often include closing charges, which include the cost of an appraisal on the collateral property.

Since the Tax Cuts and Jobs Act of 2017, interest paid on a HELOC is only deductible if the funds are used to “purchase, construct, or significantly renovate” the property used as collateral. 4

Business Line of Credit

Instead of taking out a fixed loan, businesses utilize them to borrow on an as-needed basis. The financial institution extending the LOC examines the market value, profitability, and risk assumed by the firm before extending a LOC. Depending on the quantity of the LOC sought and the review findings, the LOC may be unsecured or secured. The interest rate is changeable, as it is with practically all LOCs.

Demand Line of Credit

This style, which may be secured or unsecured, is seldom utilized. A demand LOC allows the lender to call the loaned money owing at any time. Depending on the conditions of the LOC, repayment might be either interest alone or interest + principle. At any moment, the borrower may spend up to the credit limit.

Securities-Backed Line of Credit (SBLOC)

This is a secured-demand LOC in which the borrower’s securities serve as collateral. An SBLOC typically allows the investor to borrow between 50% and 95% of the value of the assets in their account. SBLOCs are non-purpose loans, which means the borrower cannot utilize the funds to purchase or trade securities. Almost every other form of expense is permissible.

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SBLOCs require the borrower to make monthly interest-only payments until the loan is repaid in full or the brokerage or bank demands payment, which may occur if the investor’s portfolio value falls below the amount of the LOC.

Limitations of Lines of Credit

The key benefit of a LOC is the opportunity to borrow exactly what is required while avoiding paying interest on a huge loan. That said, borrowers need to be aware of potential problems when taking out an LOC.

  • Unsecured LOCs feature higher interest rates and credit criteria than collateralized LOCs.
  • LOC interest rates are virtually usually variable and vary greatly across lenders.
  • LOCs do not provide the same level of regulatory protection as credit cards. Penalties for late payments and going over the LOC limit can be severe.
  • Overspending on an open LOC might lead to inability to make payments.
  • Misuse of a LOC may have a negative impact on a borrower’s credit score. Depending on the severity of the situation, the services of a top credit repair firm may be worthwhile to investigate.

What are common types of lines of credit (LOCs)?

Personal, commercial, and home equity lines of credit (LOCs) are the most prevalent forms of LOCs (HELOCs).Personal LOCs are normally unsecured, however company LOCs may be either secured or unsecured. HELOCs are secured and backed by the market value of your home.

How can I use an LOC?

An LOC may be used for a variety of reasons. Paying for a wedding, a trip, or an unanticipated financial emergency are some examples.

How does an LOC affect my credit score?

When you apply for a LOC, lenders do a credit check. This causes a hard inquiry on your credit report, which reduces your credit score temporarily. If you use more than 30% of your borrowing limit, your credit score will suffer. 2

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