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What Is a Line of Credit and How Does it Work?
A personal line of credit is a loan that is very similar to a credit card as you get a specific amount of money that you can use for any purpose, and you are charged interest only on the amount that you use. When you use a line of credit, you apply once for a maximum limit and then make payments on the amount that you use, not the total limit itself. It’s a flexible borrowing option particularly useful for unexpected expenses or for paying for home improvements, education and debt refinancing.
Best line of credit providers for 2020
- SunTrust – Highest withdrawal limit
- Navy Federal – Best for longest draw period
- Wells Fargo – Lowest APR
- OnDeck – Best for small businesses
- BlueVine – Best for entrepreneurs
- Bank of America – Best for HELOC
Suntrust – Highest withdrawal limit
SunTrust offers a revolving line of credit up to $250,000 (up to $500,000 for Private Wealth Management clients) with no collateral required and no application or annual fees. The borrower must meet minimum asset requirements — investable assets of at least $100,000. A 0.25% interest rate discount is applied if payment is automatically deducted from a SunTrust account. The online application process takes only 15 minutes, but the whole procedure consists of several subsequent steps: preliminary loan decision, loan processing, the final decision and loan closing.
Navy Federal Credit Union – Best for longest draw period
Navy Federal allows HELOC borrowers to borrow up to 95% of their home’s equity with a 20-year draw period, followed by a 20-year repayment period. The credit union doesn’t charge any application, origination, annual or inactivity fee, and offers a 0.25% rate reduction with automatic payments. Navy Federal will also cover most of the closing costs, including title search, settlement, and notary fees.
Wells Fargo – Lowest APR
Wells Fargo offers lines of credit ranging from $3,000 to $100,000. The bank offers competitive rates that range from 5.74% to 24.24% APR, with at least 15.0% of approved applicants qualifying for the lowest rate available. It also charges an annual fee of $25, but no balance transfer or cash advance fees. You can apply online and get a response right away, and if you have a Wells Fargo CD or savings account, you may use it as collateral for a secured personal loan.
OnDeck – Best for small businesses
Recognizing that this flexible type of financing can be a lifeline for a small business, OnDeck created business lines of credit specially tailored for this type of borrowers. The rates start at 10.99% APR, and the total amount of the credit line can go up to $100,000 — which is flexible enough to cover various small business financing needs, from bridging short-term cash flow setbacks to taking advantage of growth opportunities as they arise. In a no-fuss 10-minute online application, this type of financing also offers an opportunity for business credit building. Unlike other online lenders, OnDeck doesn’t charge draw fees.
BlueVine – Best for entrepreneurs
BlueVine offers business lines of credit that may be suitable for entrepreneurs. Minimum qualifications for this type of loan is a credit score of 600, at least 6 months in business and $10,000 in monthly revenue. The application process is straightforward and quick as you need to provide basic details about you and your business and a bank connection or 3 most recent monthly bank statements.
Bank of America – Best for HELOCs
Compared to other lenders, Bank of America offers low, competitive home equity line of credit rates accompanied by several other benefits for borrowers. First, there’s a special intro APR at only 2.490% for the first 12 months, which later increases to 4.430%. Then, there is no application, annual and closing fees or additional costs if you want to convert your variable-rate balance to a fixed-rate loan. To top it off, if you make an initial withdrawal when you open your account, you will get a 0.10% interest rate discount for each $10,000 withdrawn (up to a maximum discount of 1.50%). The draw period is comparable with most other lenders — 10 years, followed by a 20-year repayment period.
What is a line of credit?
Line of credit is a convenient and flexible borrowing option that gives you access to a specific, pre-approved amount of money that you can later use for any reason, at any time. You will only pay interest on what you actually use. You can vary repayments as you see fit, although there will usually be a minimum monthly payment just as in the case of credit cards.
One of the advantages of a line of credit compared to a regular loan is that it does not have to be used for a specific purpose, and no interest is charged on the unused amount.
How does a line of credit work?
Borrowers can apply for lines of credit at a bank, credit union or other financial institution. After application and approval, the funds become available fairly quickly — usually by the next business day. In the case of business lines of credit, the lender evaluates profitability and other business indicators that show the viability of your business and its ability to pay back the borrowed amount.
The funds are revolving credit, like a credit card, wherein you only have to repay the balance of what you use. Keep in mind that each time you draw on your line of credit, your monthly payment amount will change based on the balance and length of the term left.
Unlike home equity lines of credit, which are secured by the equity in your home, personal lines of credit are typically unsecured, which means the lender will not require collateral as a way of protection if you default.
Different types of lines of credit
Lines of credit can be a useful financing option for many occasions or unforeseen events, like completing home renovations, paying for a child’s education and securing additional cash flow for a business.
Business lines of credit
Cash flow is one of the key concerns for entrepreneurs and small business owners. A business line of credit can be a useful tool to get your business off the ground. This type of loan is usually used to fund working capital or short-term financing needs, like purchasing inventory, paying tax bills, paying vendors or payroll.
If your business is just starting out, a line of credit may be a helpful tool to create more consistent cash flow to cover the unpredictable costs. It is often secured by assets owned by the business, such as inventory or equipment, which is helpful as it often results in a lower interest rate.
Personal lines of credit
A personal line of credit refers to the money you borrow to cover personal expenses such as home repair, bigger purchases, significant events or just to smooth out dips in personal income. It can also be useful if you are looking to consolidate your higher-interest debts.
Home equity line of credit
If your home is worth more than your mortgage, you may be able to borrow against that difference called equity. This type of loan that uses your house as security is called a home equity line of credit.
Because it’s secured by your home, this type of credit line is usually a higher amount and interest rates are often lower compared to other financing options. Also worth noting is that you may gain tax benefits if you use your HELOC funds for home improvement.
You can apply for a HELOC with your mortgage lender or other financial institution. Most HELOCs will require an initial minimum draw, usually ranging from s $10,000 to $25,000, depending on the total amount of the line. There are two distinct phases to a HELOC:
- Draw period: when you’re able to borrow from the credit line, which typically lasts for 10 years, but can go up to 20 years with some lenders.
- Repayment period: when you can no longer borrow money against your line of credit, and you start paying back what you owe in monthly installments, which usually lasts for 20 years.
How to apply for a line of credit
To get a line of credit, you need to apply for one at a lender — a bank or other financial institution. The lender will assess and examine your creditworthiness based on your income and credit history. It is crucial to prove to the lender that you are a low-risk, creditworthy borrower.
As you’re preparing to apply for a line of credit, you may consider taking these steps:
Review your credit report
Before you apply for a line of credit, you’ll want to check your credit report with all major credit bureaus — Experian, TransUnion, and Equifax.
The law allows all U.S. citizens to access their credit information for free once every year, which is available through AnnualCreditReport.com.
Complete and update your financial paperwork
When assessing your creditworthiness, the lender will look at your income, job, where you live and any other factor that may affect your ability or willingness to repay the loan. Make sure you have your financial paperwork in order.
If you’re applying for a HELOC or business line of credit, make sure your taxes and mortgage have been paid. You’ll also want to check if you have all your licenses and permits and if you are registered correctly with the local and federal governments.
Compare rates and other important loan terms between multiple lenders
Do your research and check the rates and terms with multiple lenders so you can get the best deal possible. Lines of credit can differ depending on the interest rates, duration, amount borrowed, draw fees and security.
You’ll want to compare potential lenders across a range of information: Will your loan have a fixed or variable interest rate? What are the payment schedules? What are the fees charged? What is the amount the lender is willing to extend?
With a HELOC, your limit depends on the market value of your home. The lender will arrive at the credit limit by subtracting what you still owe on your mortgage from about 75% to 80% of the market value of your home.
Consider this before applying for a line of credit
Annual percentage rate (APR) is one of the most important numbers to consider when comparison financing options. This rate includes the interest rate you will be charged as well as all other associated costs. It shows how much it costs you every month to use the money from the approved credit line.
Also, it is worth noting that the interest rates are usually variable, which means they can change over time, depending on the terms of the loan agreement and the general market environment.
Additionally, personal lines of credit are usually unsecured, while business lines of credit and HELOC are secured. Secured loans typically come with a lower interest rate but require collateral.
It is essential to keep in mind that lines of credit are most useful when used for covering short-term, undefined expenses that you’ll be able to repay reasonably quickly. Taking out a line of credit can be a good decision when you are recovering from financial hardship, when you want to start a new business or invest in a new market opportunity that will get your existing business off the ground. On the other hand, if you want to finance a specific purchase, you may want to consider taking a loan instead of a line of credit, as loans will usually have lower rates.
Lines of credit are a very convenient way to cover costs, but make sure that the amount you borrow and other borrowing terms are in line with your capacity to repay the debt. If you’re taking out a business line of credit, make sure you consider all your options and the reasons why you need the funds in the first place. For example, a line of credit will make sense if you need funds for short term bridge financing, but will not be appropriate for capital expenditure, as these will be better suited for a business loan.
One of the biggest advantages of a line of credit is that you get the funds very quickly, but here also lies the danger, as it can lead the way to excessive debt.
How to use a line of credit
Here are some tips on how to use a line of credit to make the most of this financing option:
- Plan ahead and use it only for significant purchases while paying for smaller purchases from your own funds.
- Know the terms of your agreement. This includes draw periods, when you have access to funds and making interest-only payments.
- Make early payments whenever you can, as this can cut down on future interest payments.
Alternatives to a line of credit
Although a line of credit is similar to credit cards, they often come with lower interest rates, making them a much better choice for borrowing. Compared to loans, they offer variable access to funds and flexible repayment schedule instead of a lump-sum, single-purpose loan that is repaid in fixed installments. However, they tend to have higher rates compared to loans.
A solid alternative if you need to finance a purchase, but want to avoid fees is a balance transfer using a different credit card. The key here is to find a balance transfer card that offers 0% APR on purchases and not just balance transfers. Some cards also offer rewards or cashback on purchases, which means you could be earning around 1% cash back for the purchases you make at 0% APR. While this sounds like a great deal, be careful not to end up overspending.
You’ll also want to make sure you can afford to pay back the whole balance you charge during your card’s 0% APR offer. Because if you don’t pay it back, any remaining balance at the end of the offer will start incurring the normal credit card interest rate, which could be very high. Make sure you read the fine print and understand how long you will not be paying interest, whether there are any fees and all other important details that may impact the amount of money you end up owning.
How does credit work?
Having that line of credit can improve your credit, which means better offers. Here’s how it works.
Your credit score is like a grade and your credit files are like your report card. Lenders send your credit habits to the three major credit bureaus, which in turn generate scores using models like that of FICO.
When you pay on time and in full on a credit card, a loan or a line of credit, it’s reflected in your credit files, which causes your score to go up. When your score rises, you become more attractive to lenders, which means you qualify for better offers. That means the interest rates you are offered can be lower, and your line of credit might be higher.
It takes time to increase your score, but not as long as you’d think. If you have a thin file, or not much credit history, it can take a few short months to improve your score. However, one mistake can cause your score to drop a dozen points or more, and it can take some time to recover it.
Bottom line? Pay on time and in full, check your credit files periodically for accuracy, and you’ll be fine.
We welcome your feedback on this article and would love to hear about your experience with the personal lines of credit we recommend. Contact us at email@example.com with comments or questions.