What Is a Line of Credit?

How do lines of credit work?

A line of credit, more commonly known as a personal line of credit (PLOC), is technically a type of loan. Unlike with a traditional personal loan, you’ll only pay interest on the amount of money you use.

With a line of credit, you’ll only pay interest on what you borrow.

When you’re approved for a line of credit, the lender agrees to give you access to a specified amount of money. You can spend as much of the maximum amount as you’d like. Once you pay it back, the amount of credit you have adjusts accordingly. This is known as revolving credit.

Line of credit example

For example, say you have a $25,000 line of credit to help you remodel your home. You use $4,000 on an initial expense. You would then owe $4,000 plus interest, and you would have $21,000 remaining on the line of credit. Once you pay back what you’ve borrowed, you’ll again have access to your full line of credit.

Depending on how the lender structures the line of credit, you may have a draw period that lasts from three to 10 years, followed by a repayment period of equal length where you can no longer borrow and must pay off the debt.

How to get a line of credit

To get a line of credit, a borrower must be approved by the lender. Approval usually depends on the applicant's credit score, credit history, employment, income, current debts and debt-to-income (DTI) ratio.

Line of credit uses

Typically, a line of credit isn't intended to fund a significant one-time purchase like a car or a down payment on a home. This type of loan works best when the total cost of a project is somewhat undefined and you might need to withdraw funds a handful of times throughout the course of a few years. Having a line of credit can help you avoid taking out multiple personal loans and give you greater overall flexibility.

Line of credit uses for personal use

A line of credit may be a good fit if you:

• Are renovating your home
• Want emergency fund access
• Have irregular income or expenses

Line of credit uses for businesses

Businesses may use lines of credit to:

• Take advantage of investment opportunities
• Expand operations
• Purchase new equipment
• Meet capital needs

» RELATED: Business loan types

Line of credit terms and fees

Here are some line of credit terms and fees to be aware of:

Line of credit terms

Before taking out a line of credit, you should know the following terms:

• Draw period: This refers to the period of time where you can borrow funds, up to your approved credit limit. Draw periods generally last three to 10 years.
• Repayment period: After the draw period ends, the repayment period will start. This is when you’ll pay back the funds you’ve borrowed. Repayment periods are longer than draw periods and typically last anywhere from five to 20 years.

Line of credit fees

Some common fees you might see when looking at different lines of credit include:

• Monthly or annual account maintenance fees
• Origination fees
• Transaction fees
• Over-limit fees
• Late fees

Lines of credit vs. personal loans

With a personal loan, you typically receive a lump sum and have a fixed amount of time to pay it back, plus interest and fees. A line of credit lets you take out up to a certain amount of money at any given time, but you only pay interest on the portion of the money you withdraw.

Lines of credit usually have variable rates, while personal loans tend to have fixed rates.

Interest rates

A line of credit often has a variable interest rate that adjusts according to market conditions. When interest rates are high, the cost of accessing money in a line of credit increases. In most cases, personal loans have fixed interest rates, so the borrower's monthly payment stays the same throughout the loan term.

Qualifications and approval

Whether you’re trying to get a line of credit or a personal loan, your lender will collect your personal information and look at your credit history to evaluate how much of a risk you pose. Applicants with good to excellent credit pay less interest than applicants with fair, poor or no credit history.

The process of getting approved for a line of credit is similar to applying for a personal loan and may take about the same amount of time, depending on the lender.

» MORE: How to get approved for a personal loan

Lines of credit vs. credit cards

Lines of credit and credit cards are both types of revolving credit with variable interest rates. They tend to charge similar annual percentage rates (APRs), though lines of credit typically have slightly lower APRs than credit cards. They also both come in secured or unsecured forms, though unsecured lines of credit and credit cards tend to be more common.

Grace periods and payment

While many lines of credit don’t offer grace periods, some lines of credit, such as home equity lines of credit (HELOCs) typically offer short grace periods (usually five to 15 days) before charging late fees. However, credit cards typically have longer grace periods (usually 20 to 30 days) before payments are due.

Limits and perks

Lines of credit typically have much higher credit limits than credit cards, though credit cards offer some benefits that lines of credit don’t offer, such as cash-back rewards, points or miles.

Types of lines of credit

The main two types of lines of credit are unsecured and secured lines of credit.

Unsecured lines of credit

Personal lines of credit typically offer unsecured funds. That means you won’t have to put down collateral, so the lender can’t take any of your assets if you default or fail to repay your loan. For this reason, they typically have stricter credit requirements, which means you may have a tougher time getting approved if you don’t have a good credit score.

Unsecured lines of credit also typically have higher interest rates than secured lines of credit.

Secured lines of credit

A secured line of credit might give you access to more funds and a lower interest rate.

With a secured line of credit, the lender may be more flexible when it comes to approving your loan application because the loan is backed by collateral. You may also pay less interest with a secured line of credit than you would with an unsecured line of credit.

Since secured lines of credit require collateral, the lender can take your secured assets if you fail to repay the loan. For instance, a home equity line of credit uses your home as collateral. If you fail to pay back the loan as agreed, the lender could start the foreclosure process.

One advantage to a HELOC is that you may be able to deduct the interest on your taxes if you use the money to improve your home. Consult a tax expert so you understand how deductions may apply to your situation.

What to consider before taking out a line of credit

Like other loan types, a line of credit can be a useful financial tool. You only borrow and pay interest on the money you need, and you can use funds for many purposes. Lenders also offer both unsecured and secured lines of credit, and you can typically get funds quickly.

For example, Gina, a reviewer from Nebraska, appreciated how quickly they were able to access funds.

“Once approved[,] I requested the amount needed for my line of credit. I requested some money on a Friday and had my cash by Monday. Keep in mind[,] this credit is going to cost me[,] but the rates and fees are clear if you read them.”

However, because the interest rate is usually variable, it can be difficult to predict future borrowing costs. Lenders may also charge a variety of fees, such as annual fees, late fees and origination fees. Also, once you open a line of credit, the easy access to credit may lead to overspending.

FAQ

Bottom line

A line of credit can be a powerful tool to help you reach your goals if you want access to funds during a financial emergency or if you want to start a project and are unsure of the total costs. However, like any type of credit, a line of credit can be expensive due to associated fees like account management charges or loan origination fees.

If you’re interested in getting a line of credit, talk with a representative from your bank or credit union to see if it offers this type of loan. No matter what type of loan you get, be sure to shop around to get the lowest rates and best terms.