Line of Credit Definition, Pros and Cons, Types and Uses

A line of credit is a loan account that helps borrowers borrow financing continuously whenever necessary. The lender determines the maximum credit amount a business is eligible to borrow, and the credit line functions as an open-ended loan that entitles the borrower to withdraw funds at their preference. A line of credit loan permits the creditor to withdraw funds indefinitely if the credit limit is not exceeded, contrary to a conventional business loan. A line of credit loan differs from a conventional business loan in that only the amount utilized must be repaid.

The diverse types of line of credit loans include business lines of credit, personal lines of credit, home equity lines of credit (HELOCs), securities-backed lines of credit (SBLOCs), and demand lines of credit. Business lines of credit offer adjustable funding for organizations based on market value and profitability. Personal lines of credit provide unsecured funds for various purposes, requiring a consistent income and good credit history. HELOCs are secured by a home’s market value, allowing creditors to borrow against the equity in their property. SBLOCs use securities as collateral, enabling investors to borrow against their investment portfolios. Demand lines of credit allow lenders to demand repayment at any time and are either secured or unsecured, depending on the terms.

Using a line of credit offers the advantage of having readily available cash for various purchases without the need for repeated loan applications. It allows for flexibility in spending, from everyday items to larger expenses like home renovations or vacations. Establishing a line of credit at the same institution as a bank account facilitates overdraft transfers, minimizing fees. Low interest rates and the absence of penalties for early repayment are further benefits. The temptation to overspend and accumulate debt is a significant drawback with revolving credit. Collateral is required for certain accounts, posing a risk of asset seizure in case of default. Failure to repay on time leads to interest accumulation and potential changes in credit limits and interest rates by the lender, extending the repayment period.

What is a Line of Credit?

A Line of credit is a pre-approved loan that lets a creditor borrow funds as needed. Credit lines are either flexible or backed by an asset like a mortgage. A home equity line of credit (HELOC) is secured by a home, while a personal line is unsecured.

A borrower uses a credit line simultaneously or in smaller sums as needed. Homeowners pay down credit lines monthly to upgrade their homes, and credit lines help families afford pricey holidays. Lines of credit have a 5-10-year lending and repayment tenure. Pay off the balance or renew the line of credit with new terms after the term. Unsecured and secured lines of credit exist and depend only on their projected debt repayment capabilities. A creditor’s credit score, history, and income are reviewed by lenders. The other secures the loan with a valuable asset like their home. 

How does the Line of Credit Work?

A line of credit works by granting a debtor access to funds up to a predetermined limit.  A creditor’s available credit decreases accordingly as they utilize their credit line. Credit is replenished when payments are made. A debtor accesses their credit line through various means, such as a debit card, paper checks, electronic transfers, or in-person withdrawals, depending on where a debtor opened it. 

Repayment plans include paying the balance in full or over time, with interest charged only on the portion of the credit line utilized. For instance, the borrower only accrues interest on the $12,000 borrowed if a creditor has a $20,000 line of credit and uses $12,000 during the draw period throughout the repayment period.

How can a Line of Credit Benefit Your Financial Strategy?

A line of credit can benefit your financial strategy in three ways. Firstly, a line of credit provides flexibility and quick access to funds, allowing debtors to cover unexpected expenses, pay bills, or undertake projects promptly without going through a lengthy approval process each time. For example, a home equity line of credit (HELOC) is a cost-effective means to finance renovations, consolidate high-interest debts, or handle emergency repairs if a borrower is a homeowner. Secondly, a personal line of credit offers convenience for managing day-to-day expenses, such as covering unplanned medical bills or car repairs. Lastly, lines of credit come with lower interest rates than credit cards, making them a more affordable option for borrowing. Using a line of credit wisely and paying attention to interest accrual helps creditors maintain financial flexibility and minimize borrowing costs, strengthening their financial position.

An example of the advantages of a line of credit is managing financial flow for a startup company. Imagine a retail establishment whose revenue fluctuates throughout the day. Their financial reserves are restricted during the busy holiday season, so they must acquire additional inventory to meet customer demand. A business line of credit is an alternative to short-term loans or forgoing potential sales. The store proprietor has been granted a line of credit for $50,000, which carries an annual percentage rate of 10% (APR). They utilize $30,000 from the line of credit to purchase additional inventory during the holiday season. They are capable of satisfying customer requirements and augmenting sales by $60,000, thereby producing a profit of $20,000.

The store proprietor repaid the $30,000 borrowed from the line of credit within three months following the waning of the holiday rush. The loan accrues interest at a rate of 10% over the term ($30,000 x 10% APR x 3/12). The increased sales and profits exceeded the financing costs, leading to a net gain for the business, notwithstanding the interest payments. 

How can a Line of Credit Be Used for Debt Consolidation?

A line of credit can be used for debt consolidation by combining credit card balances and personal loans. The attainable advantages of consolidating numerous debts into a solitary line of credit for debtors include reduced interest rates and more feasible monthly payments. The methodology allows creditors to withdraw funds to repay delinquent debts, incurring interest charges solely on the borrowed funds. Exercise prudence and refrain from added debt to avert further financial burden. Debtors must diligently assess the line of credit’s associated fees and terms to ascertain whether they are consistent with their financial circumstances and objectives for debt consolidation.

The first step in using a line of credit for debt consolidation is to gather information such as outstanding debts, ideally creditor names, account numbers, amounts owed, and payment addresses. Second, assess the terms and conditions of various debt consolidation prospects, such as balance transfer credit cards, personal loans, home equity loans, or credit consolidation loans. Consider factors like interest rates, fees, and probable influence on the credit score.  

Third, apply for the chosen debt consolidation tool, submit the necessary documentation, and undergo a credit check once the most suitable option is determined. Fourth, creating a budget to manage finances effectively, avoid accruing new debt, and set up automatic payments to ensure timely repayment are crucial after obtaining the line of credit. Lastly, monitoring the credit utilization ratio and staying disciplined in repayment efforts help improve a debtor’s financial situation and expedite their journey to becoming debt-free. The primary advantage of debt consolidation with a line of credit is the option to merge various loans into a sole account, streamlining payments and lowering total interest rates.

What are the Different Types of Lines of Credit?

The different types of Lines of Credit are listed below.

• Business Line of Credit: A business line of credit allows organizations to acquire funds as needed instead of obtaining a fixed loan. The financial institution extending the LOC assesses the company’s market value, profitability, and assumed risk. A secured or unsecured LOC depends on the evaluation and the amount requested. The interest rate fluctuates similarly to the vast majority of LOCs.
• Personal Line of Credit: A personal line of credit grants the borrower access to unsecured funds reimbursable upon repayment. A personal LOC requires a consistent income, a credit score of 670 or higher, and a history of no defaults. Personal LOCs do not require collateral, while savings and collateral in the form of equities or certificates of deposit (CDs) are advantageous. Personal LOCs are utilized for entertainment, emergencies, marriages, overdraft protection, travel, and assisting creditors with irregular income in smoothing rough spots.
• Home Equity Line of Credit (HELOC): HELOC is the most secured LOC. The home’s market value minus the amount due secures a HELOC, determining its size. The credit limit is 75% or 80% of the home’s market value minus the mortgage. A 10-year draw duration allows borrowers to borrow, repay, and borrow again with HELOCs. The sum is payable after the draw period, or the loan is extended to pay off the sum over time. Closing fees for HELOCs include a collateral property appraisal. 
• Securities-Backed Line of Credit (SBLOC): SBLOC is a special secured-demand LOC in which the borrower’s securities are collateral. An SBLOC permits the investor to borrow between 50% and 95% of the value of the assets in their account. The borrower is not permitted to use the funds to purchase or sell securities, as SBLOCs are unsecured loans. Almost any other expenditure type is permissible. SBLOCs entail monthly interest-only payments from the borrower until the loan is fully repaid or the brokerage or bank demands payment. The latter scenario occurs if the investor’s portfolio value descends below the LOC.
• Demand Line of Credit(LOC): Demand lines of credit are not often used but are sometimes protected. They allow the lender to demand repayment at any time. The terms of the LOC determine whether the loan repayment (as long as the loan is not repaid) consists of only interest or interest and principal. The borrower is permitted to use the credit limit at any time.

How do You Qualify for A Line of Credit?

To qualify for a Line of Credit, follow the 10 steps listed below.

1. Identify the types of Lines of Credit. A Personal Line of Credit is unsecured for personal expenses. The borrower’s home equity secures a home Equity Line of Credit (HELOC) and offers reduced interest rates. A Business Line of Credit helps oversee business expenses and be secured or unsecured, depending on the lender’s criteria.
2. Assess a debtor’s creditworthiness. Review the credit score to understand where it stands regarding creditworthiness. Follow tips like paying bills on time, reducing debt, and checking for errors to improve the debtor’s credit score.
3. Prepare the financial documents. Gather essential documents like identification, proof of income, bank statements, credit reports, and collateral documents if the lender requires them. Ensure all documents are organized and current before applying for a line of credit.
4. Obtain proof of income and employment. Furnish documentation such as pay stubs, tax returns, bank statements, and an employment verification letter to confirm a debtor’s income and employment status. These documents help lenders assess the debtor’s ability to repay the line of credit.
5. Understand Debt-to-Income (DTI) Ratio. Calculate the DTI ratio by dividing a debtor’s total monthly debt payments by their gross monthly income and multiplying by 100. Strategies for improving the DTI ratio include reducing debt, increasing income, and consolidating debts where possible.
6. Complete the additional requirements for Business Lines of Credit. Businesses need to submit a business plan, business financials, and a demonstration of creditworthiness to qualify for a line of credit. These additional requirements help lenders assess the viability and stability of the business.
7. Choose between Secured and Unsecured Lines of Credit. Understand the differences between secured and unsecured lines of credit, including interest rates and collateral requirements. Consider the pros and cons of each type before deciding which option best suits the creditor’s financial necessities and circumstances.
8. Build a relationship with lenders. Maintain regular communication with lenders, meet financial commitments, and provide transparency about the current financial situation. A strong relationship with lenders improves a borrower’s chances of approval and leads to better terms for a line of credit.
9. Avoid common mistakes. Ensure all applications are complete and accurate to avoid delays or rejections. Regularly check the credit report for errors and address them promptly to maintain an accurate credit profile.
10. Optimize debtor’s application. Apply for a line of credit when financially stable and have a strong credit profile. Customize the loan application to meet each lender’s specific requirements and seek professional advice to improve approval chances.

What are the Pros and Cons of Using a Line of Credit?

The Pros and Cons of Using a Line of Credit are in the table below.

Pros

• The main advantage is having cash on hand when debtors need it. Debtors are not required to submit an application and wait for a loan each time they struggle to afford to make a purchase.
• Purchase virtually anything as long as the credit limit is met. A line of credit is used to acquire a home or automobile. It is utilized to finance vacations and home improvement initiatives.
• A borrower’s credit limit varies depending on what they want to buy, from candies to an expensive vehicle.
• Establishing a line of credit at the same financial institution where a debtor has a bank account enables the transfer of any overdraft from the bank account to the line of credit, circumventing superfluous fees.
• The absence of fees or penalties for early credit repayment depends on the financial institution with which the line of credit is established.
• The rates of interest are lower than the rates of the loans.
• Almost anything a borrower wants is bought up to their card limit.

Cons

• The most significant drawback is temptation. Creditors are tempted to spend money they do not possess. Opening a second line of credit and utilizing it to its maximum capacity after the initial one is exhausted is occasionally referred to as revolving credit, which leads to significant financial distress and debt.
• Certain credit accounts demand collateral. Real estate, such as a residence, is utilized as collateral. Defaulting a mortgage is risky since a lender is able to seize the debtor’s home legally.
• The freedom of the line of credit hurts debtors if they don’t pay it off on time. Interest accumulates and reaches a significant total.
• The lender has the capacity to change the debtor’s credit limit and interest rates. The process is mentioned in small print for some types of credit.
• Paying off credit does not mean paying off principal debt but rather paying off interest. It causes the debtor to repay the loan over an extended time.

How does a Line of Credit Differ from A Loan?

A line of credit differs from a loan primarily in how funds are obtained and paid back.  A line of credit offers flexibility by allowing borrowers to borrow money up to a preset limit, repay it, and reborrow as needs arise. A loan provides a lump sum of money upfront, used for one-time expenditures for financing a vehicle or a house. 

Borrowers receive the full amount instantly and make periodic fixed payments over a set course until the loan is fully paid off with a loan. A line of credit, such as a credit card or a home equity line of credit (HELOC), functions as a revolving account where borrowers borrow and repay funds repeatedly without needing to apply for a new loan each time. 

For instance, with a credit card, borrowers make purchases up to their credit limit, pay off the balance, and then borrow again.  Lines of credit offer more flexibility in repayment terms, allowing borrowers to pay only the minimum needed amount or more if they choose, while fixed-interest rate loans require borrowers to make fixed monthly payments. Interest is levied on the amount lent for loans and lines of credit, but with lines of credit like credit cards, interest is avoided if the balance is paid in full each month. 

The loans and lines of credit affect a borrower’s credit score and provide secured and unsecured options. Loans are ideal for significant, one-time expenses, whereas lines of credit are better suited for smaller, recurring expenses or as a safety net for financial crises since they are flexible and revolving.

What are the Typical Interest Rates for A Line of Credit?

The typical interest rates for a line of credit range from 6% to 60%, depending on the creditor’s credit score. Lower credit scores mean higher interest rates and costs on a business line of credit. Long-standing business owners with good-to-excellent credit get approved for the lowest rates, while startups or creditors with poor credit face higher rates and fees. Lenders offer variable rates, such as 6.00% simple interest with Fundible, 7.99% APR with SMB Compass, or 10.25% APR with Wells Fargo. 

The interest rates charged on a business line of credit are calculated in various ways, including factor or annual percentage rates (APR), which do not always fully capture the borrowing costs. Other fees, such as annual, origination, draw, and maintenance, contribute to the cost of using a line of credit. Shop around, build strong credit scores, and explore alternatives like secured lines of credit if eligible, which offer more advantageous terms in exchange for collateral to secure the best interest loan rates on a business line of credit.

How to Effectively Manage a Line of Credit?

To effectively manage a line of credit, consider the following factors.

• Have a plan for the funds. Create a clear plan for using the funds from the line of credit. Proactively strategize spending to avoid tapping into the credit line unnecessarily. Develop a repayment plan before accessing the funds to ensure responsible financial management.
• Continually adjust usage. Alternate between periods of using the credit line and focusing on paying off the balance. Demonstrating responsible usage strengthens the creditor’s relationship with the lender and potentially leads to better terms in the future. Prioritize repayment during certain periods to avoid accumulating a balance that becomes unmanageable.
• Save it for short-term purchases. Use the credit line for short-term needs to repay promptly. Avoid using the credit line for long-term asset purchases unless the borrower pays off the balance quickly. Consider alternative financing options, such as collateralized loans or lease agreements, for long-term asset acquisitions to secure better terms.
• Be aware of costs. Monitor the interest rates associated with the line of credit, ranging from 8% to over 60%. Be mindful of additional fees, including origination, processing, and maintenance fees, which impact the cost. Track monthly payments to prevent them from becoming unmanageable, leading to missed payments or financial difficulties.

What are the Common Uses of A Line of Credit?

The common uses of a line of credit are listed below.

• Big Purchases: Prioritizing savings for big purchases is a good idea, but unexpected events mean people must find other ways to pay for things. A personal line of credit helps pay for important, pricey purchases in these scenarios. Personal lines of credit allow people to afford everything from everyday things, like household tools, to moving costs, such as truck rentals and security deposits.
• Cash Flow Management: Effectively managing personal finances involves navigating the challenges of fluctuating due dates and cash flow. A personal line of credit is valuable when bills come due before receiving income. The flexibility of a personal line of credit alleviates the stress of financial timing mismatches, ensuring uninterrupted utility services and timely rent or mortgage payments for shelter. It helps avoid penalties, maintains a positive credit history, and covers essential transportation costs for work or school. It provides peace of mind and fosters financial stability in managing personal finances. 
• Unexpected Payments:  Having a line of credit available alleviates the stress and financial burden when faced with emergency expenses such as car repairs, home repairs, travel emergencies, or replacing stolen or damaged items. Simply draw the needed amount from the line of credit instead of applying for an emergency personal loan or accruing high credit card bills. The personal line of credit provides the financial flexibility to resolve any urgent need, whether maintaining a vehicle or home, resolving an unexpected travel need, or replacing everyday items.
• Regular Expenses: Certain monthly expenditures are excluded from the borrower’s regular monthly budget due to their recurring nature. These include buying new books and other academic supplies each semester, annual billing for services rendered, tax responsibilities, and biannual insurance premiums. An unforeseen expense is best addressed by using a line of credit.
• Home Improvements: Home upgrades, whether to increase value or fix aging issues, are costly. A Home Equity Line of Credit (HELOC) allows homeowners to use their home equity to acquire a flexible personal line of credit. A HELOC lets borrowers draw funds as needed, making staged renovations affordable, unlike lump sum loans. Budgeting is flexible since borrowers only withdraw the amount they need, reducing the pressure of repayment for unused money and ensuring interest is only paid on borrowed amounts. A HELOC gives homeowners rapid access to finances, allowing them to use cheap materials or contractor services. The line of credit covers unanticipated remodeling costs like concealed repairs or improved materials without disrupting the project as a safety net.

How does a Home Equity Line of Credit (HELOC) Work?

A Home Equity Line of Credit (HELOC) is a revolving line of credit secured by the equity in a debtor’s home. Debtors are granted a credit limit upon approval determined by the value of equity in their property up to 80% of its appraised value, though it varies depending on lender policies and borrower qualifications, reaching up to 85 or even 90%. Debtors access funds using checks, a dedicated draw debit card, or online transfers during the initial draw period, around 10 years. 

Monthly interest payments are required on the amount borrowed during such a phase, but as the creditor repays the HELOC, the funds become available again. A borrower enters a repayment period after the draw period ends when they no longer have access to funds and are required to repay the principal and any outstanding interest for 10 to 20 years. Borrowers have the option to pay principal and interest to manage their payments effectively as they transition into the repayment phase, while interest payments are the only obligation during the draw period. Monitor one’s HELOC balance during the draw period. Avoid overspending and weigh alternatives such as interest-only payments or fixed-rate conversions to align HELOC payments with the long-term financial plan, thus safeguarding financial stability and protecting the home from risks.

How to Increase Your Line of Credit Limit?

To increase your line of credit, consider the 4 factors listed below.

• Communicate with the issuer online. Logging onto the debtor’s credit card account and selecting “request credit limit increase” is the easiest approach to increase their credit limit. Select the option/offer and answer questions. Many issuers demand a form, so be prepared to provide current income or housing expenditures and the additional credit amount needed before applying.
• Get in touch with customer support. Debtors contact their card issuer’s customer service number on the back of the card to request a higher credit limit. The requester must provide fundamental information about their financial situation and be prepared to justify the need for the increase, similar to the online request method. Additional details on earnings and expenses are required. Approval takes several days, and the requests are approved during the call.
• Accept an offer from the issuer. Watch out for offers from the issuer to raise the already cleared limit. These come in the mail, via email, or when a debtor logs into their account. Borrowers quickly get more credit with these automatic increase deals because the issuer has checked their eligibility and creditworthiness. Borrowers don’t have to go through any hoops or a credit check. Change the income information online in the credit card account to get a better chance of these offers.
• Get a new card to boost the credit score. Applying for a new credit card increases a debtor’s available credit if it is time for a new card to more closely suit one’s lifestyle and requirements. Opt for a credit card that provides practical benefits and rewards instead of merely increasing available credit. Closing an existing credit card, which shortens the duration of a creditor’s credit history and diminishes their available credit, results in a lower credit score.

What are the Risks of Having a Line of Credit?

The risks of having a line of credit are listed below.

• High Costs: Business lines of credit levy high interest rates in the double-digit APR range, which increases the borrowing cost. Hidden fees such as initiation, processing, maintenance, and penalties for non-sufficient funds (NSF) and late payments further escalate the expenses involved with the credit line.
• Potential for Predatory Practices: Engage in predatory practices, charging excessive interest rates and imposing unfair policies, although many business lines of credit are legitimate and offered by reputable financial institutions. Business owners must carefully scrutinize offers and terms to avoid falling victim to predatory lending practices that harm their financial stability.
• Time-Consuming Application Procedure: Applying for a business line of credit entails gathering and submitting various documents, including business and personal bank statements, tax returns, profit and loss statements, and business documents. The extensive documentation requirements and complex application process make obtaining a business line of credit more time-consuming than other financing options, such as secured installment loans or credit cards.
• Temptation to Overspend: Business lines of credit provide the flexibility to act on opportunities, leading to the temptation to borrow excessively and spend profits on interest payments. Businesses accumulate debt beyond their means without proper financial discipline and control, compromising their financial health in the long run.
• Limited Credit Limits: Business lines of credit offer higher limits than credit cards but still have lower limits than installment loans. A credit limit is not an effective financing solution if it is insufficient to meet the business’s needs, leading to debt accumulation without achieving the desired goals.

How can a Line of Credit Impact Your Credit Score?

A line of credit can impact your credit score in three ways. First, positive behaviors such as broadening a credit mix by opening a new line of credit boost a credit score. It shows lenders that a borrower proficiently manages different types of credit, lowering their lending risk. 

Second, using the new credit account responsibly by making timely payments helps establish a positive payment history, which is vital for a good credit score. However, negative behaviors such as opening multiple new accounts within a short period or utilizing a portion of a debtor’s existing credit damage their credit score. It happens because new credit inquiries and increased credit utilization lower one’s score. 

Credit utilization, the ratio of credit balances to credit limits, plays a significant role in credit score calculation. Lastly, opening new credit accounts increases the credit available to a debtor, potentially lowering their credit utilization ratio and positively affecting their score if they maintain low balances.

What should You Consider Before Opening a Line of Credit?

The things you should consider before opening a line of credit are listed below.

• Understanding How it Works: A business line of credit operates similarly to a credit card, allowing creditors to borrow money up to a predetermined limit. The funds become available for borrowing again as the borrower repays the borrowed amount, providing a revolving source of financing for their business’s needs.
• Terms of Credit: Thoroughly review the terms associated with the line of credit before applying. Determine the frequency of required payments, the repayment period, and whether there are any prepayment penalties. Lines of credit offer flexibility in payment intervals, unlike conventional loans, such as monthly or weekly options.
• Total Cost and Fees: Calculate the costs and fees associated with borrowing from the line of credit, including interest rates, potential penalties for late payments, and any charges for drawing down funds or maintaining the credit line, even if it remains unused.
• Access to Funds: Evaluate how quickly a creditor access funds from the line of credit in urgent situations such as meeting payroll during cash flow shortages. Some lines of credit offer expedited access, providing funds as soon as the next business day, while others have longer processing times.
• Secured vs. Unsecured: Determine whether the line of credit is secured or unsecured. Secured lines of credit require collateral, such as business assets, while unsecured lines do not. Secured lines offer lower interest rates but require collateral, making them more accessible to businesses with established assets.
• Requirements and Eligibility: Understand the lender’s approval requirements, as they vary significantly. Traditional banks have stringent criteria, such as minimum revenue thresholds or business longevity requirements, while alternative lenders have more flexible eligibility criteria.
• Impact on Credit Rating: Consider how using a business line of credit impacts a debtor’s business’s credit rating. Responsible utilization and timely repayment improve a credit score, making accessing future financing options or increasing the credit limit easier.

What is the Difference Between a Personal Line of Credit and A Business Line of Credit?

The difference between a personal line of credit and a business line of credit lies in their intended purposes and approval criteria. A personal line of credit is sought by creditors for personal financial reasons, offering them ease in accessing funds for various needs such as emergencies, home improvements, or debt consolidation. 

A business line of credit is designed for businesses to manage cash flow fluctuations, cover operational expenses, or seize growth prospects. The approval criteria of the two types of credit operate similarly. Borrowers are approved for a preset lump sum of money to draw upon as needed and repay within a specified time frame. 
A personal line of credit heavily relies on the borrower’s credit score and requires collateral or a personal guarantee for approval. A business line of credit evaluates the financial health and performance of the business, considering factors such as revenue, cash flow, and business credit history. Business lines of credit are tailored to cover specific business expenses and come with higher interest rates, while personal lines of credit offer flexibility in usage and have lower interest rates than credit cards. Understanding these differences is crucial for creditors and business owners seeking financing options aligned with their needs and circumstances.