Lines of Credit: The Basics

When people need money, the last thing on their mind is to apply for a line of credit. Going to a bank for a standard fixed- or variable-rate loan, using credit cards, borrowing from friends or family, or resorting to specialist peer-to-peer or social lending or donation services on the internet are the first things that spring to mind. Pawnshops and payday lenders are available in the most desperate of situations.

Credit lines have been used by businesses for years to cover working capital requirements and/or take advantage of strategic investment opportunities, but they have yet to catch on with people. Some of this may be related to the fact that banks seldom promote credit lines, and prospective borrowers do not bother to inquire. The only possible credit line borrowing is a home equity line of credit, or HELOC. However, it is a loan secured by the borrower’s property, which has its own set of concerns and hazards. 1

Here, then, are some of the basics about lines of credit.

Key Takeaways

• A line of credit is a flexible loan from a financial institution that consists of a set amount of money that you may borrow when you need it and return either immediately or over time.
• When money is borrowed, interest is levied on a line of credit.
• Lines of credit are often used to bridge gaps in irregular monthly revenue or to fund a project whose cost cannot be forecast in advance.

What Is a Line of Credit?

A bank or financial institution’s line of credit is a flexible loan. A line of credit is a set amount of money that you may borrow as required and then return immediately or over a predetermined length of time, similar to a credit card that provides you a restricted amount of funds—funds that you can spend when, if, and how you please. A line of credit, like a loan, will charge interest as soon as money is borrowed, and borrowers must be authorized by the bank, with approval based on the borrower’s credit rating and/or connection with the bank. It is important to note that interest rates are often changeable, making it impossible to forecast how much money you will end up paying back. 1

Lines of credit are less risky income streams than credit card loans, but they complicate a bank’s earning asset management considerably since outstanding amounts cannot be regulated after the line of credit is granted. They address the problem that most clients’ banks are not especially interested in financing one-time personal loans, particularly unsecured loans. Similarly, a borrower cannot afford to take out a loan every month or two, return it, and then borrow again. Lines of credit address all of these difficulties by making a predetermined amount of money accessible to the borrower as and when it is required.

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How Line of Credit Works

When a Line of Credit Is Useful

In general, lines of credit are not meant to be used to support one-time purchases such as homes or vehicles (which are covered by mortgages and auto loans, respectively), but they may be used to buy products for which a bank would not ordinarily approve a loan. Individual lines of credit are often meant for the same fundamental reason as corporate lines of credit: to smooth out the vagaries of changing monthly income and spending or to finance projects where determining the precise sums required in advance may be challenging.

Consider a self-employed individual whose monthly revenue is sporadic or who has a large, sometimes unexpected, wait between executing the task and receiving payment. While the individual may normally depend on credit cards to cope with cash-flow issues, a line of credit might be a less expensive solution (it often provides lower interest rates) with more flexible repayment schedules.

In brief, lines of credit may be beneficial in circumstances where there will be frequent financial outlays but the amounts are unknown ahead of time and/or the suppliers do not take credit cards, as well as instances requiring big cash deposits—weddings are a notable example. Similarly, during the housing boom, lines of credit were often used to support house remodeling or refurbishment projects. People would typically seek a mortgage to purchase a home plus a line of credit to assist pay any improvements or repairs that were required.

Personal lines of credit have also surfaced as part of overdraft protection programs provided by banks. 2 While not all banks are keen to present overdraft protection as a loan product (“It’s a service, not a loan!”), many are. However, this is another example of using a line of credit as a source of emergency finances on an as-needed basis.

When you apply to a bank for a line of credit, your credit is always evaluated.

The Problems with Lines of Credit

Lines of credit, like any lending product, have the potential to be both beneficial and hazardous. If investors use a line of credit, they must pay it back (and the terms for such paybacks are spelled out at the time when the line of credit is initially granted).As a result, there is a credit review procedure in place, and would-be consumers with low credit will have a considerably more difficult time being authorized.

It’s also not free money. Unsecured lines of credit—that is, credit that is not tied to the equity in your home or other valuable property—are certainly less expensive than loans from pawnshops or payday lenders, and they are usually less expensive than credit cards, but they are more expensive than traditional secured loans, such as mortgages or auto loans. The interest on a line of credit is usually not tax deductible.

Some banks may charge a monthly or yearly maintenance fee if you do not utilize the line of credit, and interest begins to accrue as soon as money is borrowed. Because lines of credit may be drawn on and returned on an as-needed basis, some borrowers may find the interest calculations more confusing and be shocked at how much interest they wind up paying.

Comparing Lines of Credit to Other Types of Borrowing

As previously said, there are many similarities between lines of credit and other types of lending, but there are also significant variances that borrowers must grasp.

Credit Cards

Lines of credit, like credit cards, essentially have predetermined limits—you are allowed to borrow a particular amount of money and no more. Also, like with credit cards, regulations for exceeding that limit vary by lender, while banks are less eager than credit cards to promptly authorize overages (instead, they often look to renegotiate the line of credit and increase the borrowing limit).Again, as with plastic, the loan is effectively preapproved, and the funds are there for use anytime the borrower desires. Finally, although credit cards and lines of credit may have yearly fees, none charges interest until an amount is owed.

Lines of credit, unlike credit cards, may be backed by real estate. Home equity lines of credit (HELOCs) were immensely popular with both loan officers and borrowers prior to the housing meltdown. While HELOCs are becoming more difficult to get, they are still accessible and often have cheaper interest rates. 3 Credit cards will always have minimum monthly payments, and if those payments are not made, the interest rate will be dramatically increased. Lines of credit may not have the same immediate monthly payback restrictions as credit cards.

Loans

A line of credit, like a regular loan, needs acceptable credit and return of the money, and also charges interest on any monies borrowed. Similarly to a loan, opening, utilizing, and repaying a line of credit may improve a borrower’s credit score.

Unlike a loan, which is typically for a specific sum for a fixed period of time with a predetermined repayment plan, a line of credit provides greater flexibility and, in most cases, a variable rate of interest. 1 When interest rates rise, your line of credit will cost more, which is not the case with a fixed-rate loan. There are also less limits on how cash obtained via a line of credit may be used. A mortgage must be used to buy the specified property, and an auto loan must be used to purchase the stated automobile, but a line of credit may be used at the borrower’s option.

If you determine that a loan is the best option for you, locating the finest location to borrow might be especially difficult if you are in a financial emergency and need money quickly. Accessing cash fast may appear even more difficult for people who have less-than-perfect credit. Fortunately, even if you have bad credit, there are a number of emergency loan choices accessible to you.

Payday and Pawn Loans

There are some apparent parallels between lines of credit and payday and pawn loans, however this is primarily because many payday or pawn loan customers are “frequent flyers” who borrow, repay, or extend their loans on a regular basis (paying very high fees and interest along the way).Similarly, a pawnbroker or payday lender doesn’t care what a borrower does with the cash as long as the loan is returned and all costs are paid.

The discrepancies, however, are significant. The cost of cash for everyone who qualifies for a line of credit will be far cheaper than the cost of a payday or pawn loan. Similarly, the credit assessment procedure for a payday or pawn loan is more easier and less demanding (there may be no credit check at all), and you obtain your cash much, much faster. In addition, payday lenders and pawnbrokers seldom provide the large sums of money that are often accepted in credit lines. Banks, on the other hand, seldom bother with credit lines as tiny as the usual payday or pawn loan.

The Bottom Line

Credit lines, like any other financial instrument, are neither good nor bad fundamentally. It all depends on how people utilize them. On the one hand, excessive borrowing against a line of credit may lead to financial difficulty just as easily as excessive credit card spending. Lines of credit, on the other hand, might be cost-effective solutions to monthly financial fluctuations or performing a complex transaction such as a wedding or house improvement. Borrowers should read the conditions carefully (especially the fees, interest rate, and payback schedule), shop around, and don’t be hesitant to ask plenty of questions before signing.

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