What Is a Line of Credit and How Does it Work?

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Your local bank or mortgage lender may be able to offer you a line of credit, though it’s not always advertised.

Life is full of unpredictable expenses like car repairs, home maintenance, or medical bills. In such cases, a line of credit could help you afford the costs, but what kind of funding is best when you really just need cash for an emergency? Credit cards and even payday loans could help, but those options usually come at a high price, which means they may keep you in debt much longer than you’d like.

If you want a smarter loan option, consider the lesser-used line of credit, which has some great benefits for consumers. Banks don’t usually advertise lines of credit, but they can be a much more budget-friendly solution than the high interest rates that come with a credit card.

Here’s what a line of credit is, how it works and more importantly, how to use a line of credit to your advantage.

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What Is a Line of Credit?

A line of credit, or LOC, is a type of bank loan where you can withdraw up to an agreed upon amount. Many banks and lenders offer lines of credit for specific purposes. For instance, home equity lines of credit (HELOC) are usually used for remodeling your residence.

If you’re self-employed with cash-flow problems, or want to start a business but don’t have the collateral for inventory, you may want to think about a line of credit to give you the leverage you need.

A line of credit differs from a traditional loan, where you receive an influx of cash and immediately start making payments on the balance. A line of credit only requires you to pay interest and fees on the portion of funds you borrow.

If your line of credit is for $10,000 and you don’t withdraw any money, you won’t have to pay any interest. The entire $10,000 balance is available for qualified purchases at any time, but you only make payments on money you actually withdraw.

How Does a Line of Credit Work?

A line of credit works in a similar way to a credit card, in that you have the freedom to use the funds when it best suits you. The only advantage to a LOC versus a credit card, though, is that the interest rate is usually considerably lower.

In addition, a line of credit usually comes with a much higher account limit for spending, whereas a credit card’s limit is much lower.

You will also receive a monthly statement showing your balance, your minimum payment due, and summary of interest and fees. As long as you draw down the funds, you’ll be required to repay the money each month, as agreed upon with your financial institution.

Different Types of Lines of Credit

There are many different reasons why you may want to apply for a LOC, depending on where you are financially. It can be used to help bridge the financial gap, pay for an emergency, or even fund your child’s college education.

In many cases, a line of credit is a much cheaper option than applying for a personal loan or using a credit card for large purchases.

Check Your Personal Loan Rates

Answer a few questions to see which personal loans you pre-qualify for. The process is quick and easy, and it will not impact your credit score.

Secured and Unsecured Lines of Credit

Lines of credit fall into two overarching types:

  • Secured: A secured LOC is backed by collateral, such as a home, vehicle, boat, or other valuable asset you own. This type of loan usually comes with a much lower interest rate, since it’s less of a risk for the lender.
  • Unsecured: This is not backed by collateral, making it a bit more difficult to apply for, as it has higher interest rates to account for the greater risk.

Now that you understand the types of LOCs available, you can determine the best category based on why you need the money.

Personal Lines of Credit

If it’s attached to your personal property, making it a secured loan, the interest and fees will be quite a bit lower. If it’s not backed by any sort of collateral, making it an unsecured loan, you’ll like pay a much higher interest rate.

You can apply for a personal LOC at the same institution where you have a checking account (in fact, the account is usually required), where you can then make regular transfers into your account, or even write checks for purchases directly from the line of credit.

For the most part, you are free to use the money how you choose, but since your assets are held as collateral, they may be seized in the event you can’t pay off the balance in time.

Home Equity Lines of Credit

As mentioned above, a HELOC allows you access to the funds for home improvement projects, or repairs and emergency fixes. It’s usually backed by your home’s value and therefore considered a secured line of credit. Because of this, HELOCs generally have very low interest rates since there’s less risk to the lender.

A home equity line of credit can be applied for with your mortgage lender, or other financial institution, and comes with a set timeline for when you can withdraw the money. This “draw term” usually lasts 10 years before the line of credit will be called on for full payment.

Business Lines of Credit

When you’re ready to take your business to the next level, this may be a smart option. This type of loan is designed to fund short-term finance needs, like purchasing inventory, paying operating expenses, or buying new equipment.

If your business is just starting out, you may want to use a business LOC to create more consistent cash flow to tackle those unpredictable costs. A business line of credit is usually secured by assets owned by the business, such as inventory or equipment.

How to Properly Apply for a Line of Credit

When applying for any type of line of credit, lenders will look to see how creditworthy you are, which is proven by your ability to repay the loan and your credit score.

If you have a good credit score, your interest rate will be much lower, and your borrowing limit will be much higher. As you’re preparing to apply for a LOC, take these steps:

Review Your Credit Report

Do you know what your credit score is? When was the last time you checked your credit report? Are there any errors that need to be fixed, or do you have an account that’s overdue?

Before heading to your bank, you need to know what your overall credit history looks like so you can be prepared. You’ll want to check your report with all three of the most popular credit bureaus when possible (since you don’t which one a particular bank will be looking at): Experian, TransUnion, and Equifax.

All U.S. citizens are allowed — by law — to have access to their credit information for free on an annual basis. Simply go to annualcreditreport.com and input your information. You’ll want to print this report to take along with you when applying for a line of credit.

Gather Your Financial Records

Beware that financial institutions will likely look at your income, where you live, and what kind of job you have, along with any other factors that could benefit (or deter) you from being approved for the loan. So you’ll need copies of past tax returns, employer information, investments, and bank statements when applying.

If you’re applying for a HELOC or business LOC, have your taxes all been paid? Are your mortgage payments up to date? Do you have all your permits and licenses? Are you registered correctly with the local and federal governments?

Make sure you check all these off before applying, and that you have your financial paperwork in order.

Compare Terms and Rates With Other Lenders

Don’t settle on just one financial institution when applying for a line of credit loan. Do research and check the rates and terms with other lenders so you can get the best deal possible.

Will your loan have a fixed or variable interest rate? What are the payment schedules, and what kind of fees are attached? Can you get approved for a higher LOC balance at your local bank, versus going to a new one?

With a HELOC, your limit is based on a calculation involving the market value of your home. Subtracting what you still owe on your mortgage from about 75% to 80% of the market value of your home will determine your limit.

In other words, take what your house is worth, multiply that by about 80%, subtract what you still owe, and you’ll likely qualify for that amount.

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Consider This Before Opening a Line of Credit

If you decide you don’t want a line of credit after applying for a HELOC account, the federal Truth in Lending Act allows you to change your mind up to three days after you set it up. If you don’t feel comfortable with taking out a personal or business LOC, then don’t push the issue.

Wait until you’re more financially stable and can afford to repay the funds you use. In some instances, you’ll need to bring the balance of the LOC account to zero at the end of each year.

Depending on the agreement signed with your financial institution, you may be required to pay back the balance of the line of credit at any time the bank chooses. When a bank “calls” your loan, this means your full balance is due and your line of credit will be reduced. What makes a bank request your loan payable on demand?

There are several factors, including: times of economic uncertainty; if you have a poor repayment history; risky spending behavior; a change in your income; or any other red flags that pop up.

It’s important to budget your funds to cover any annual lump-sum payments, and to not use more credit than is absolutely necessary. So be cautious when taking down money from a line of credit, as you want to keep a manageable balance that you can pay back relatively quickly.

Taking out a line of credit can be a smart move in order to recover from a financial hardship, or to start a business, or invest in an upcoming opportunity. Just be sure you have all the facts, and understand the risks before applying for one.

How to Use a Line of Credit 

Once you get a line of credit, using it with discretion and foresight will help you make the most of it. Here are some tips for how to use a line of credit:

  • Use it only on the big purchases and plan those purchases ahead. For instance, if you get a line of credit to build a new fence, don’t buy the paint using the line of credit if you can pay directly. In general, pay for smaller purchases on your own. Otherwise, those small purchases can add up and you’ll end up owing interest on things you could have just purchased outright.
  • Know the terms of your agreement. For instance, many loans have windows of time where you have open access to funds and can make interest-only payments, called draw periods.
  • Make early payments if you can. This can cut down on future interest payments.

If you plan ahead on how you use your line of credit, you won’t risk going over budget and having to borrow more.

Alternatives to a Line of Credit

While you my be thinking a line of credit is ideal for emergency expenses, there’s one other option to consider that could help you avoid fees and interest altogether. With a balance transfer credit card that offers 0 percent APR for up to 21 months, you can avoid interest on purchases and surprise expenses and potentially pay down your debt faster.

The key to making this option work is finding a balance transfer card that offers 0 percent APR on purchases and not just balance transfers. Once you sign up for a card and receive it in the mail, you’ll also want to make sure you can afford to pay back the entire balance you charge during your card’s 0 percent APR offer. If you don’t, any remaining balance at the end of the offer will begin incurring the standard credit card interest rate, which could be very high.

Before you choose a 0 percent APR credit card, it’s important to read the fine print and understand the offer in its entirety. Make sure you know how long you will avoid paying interest, whether the card charges any fees, and any other important details to be aware of.

Some cards offer rewards on purchases as well, which means you could be earning at least 1 percent cash back for the purchases you make at 0 percent APR. While rewards are always a good thing, make sure they don’t entice you into overspending or borrowing more than you can afford to pay back.

The Bottom Line

Lines of credit can be a smart option if you’re struggling to keep up with your bills, but there are other options to consider as well. At the end of the day, the best thing you can do is to take a holistic look at your financial situation then compare loan options based on your unique needs. Borrow only what you can afford to pay back and choose a loan with the lowest costs possible. If you borrow money the right way and err on the side of caution, you will thank yourself later.

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