When individuals need money, seeking a line of credit is often the last thing that occurs to them. What comes to mind first is generally going to a bank for a traditional fixed- or variable-rate loan, using credit cards, borrowing from friends or family, or turning to specialized peer-to-peer or social lending or donation sites on the web. In the direst of circumstances, there are pawnshops or payday lenders.
Businesses have been using credit lines for years to meet working capital needs and/or take advantage of strategic investment opportunities, but they’ve never quite caught on as much with individuals. Some of this may be due to the fact that banks often don’t advertise lines of credit, and potential borrowers don’t think to ask. The only credit line borrowing that might come up is a home equity line of credit or HELOC. But that is a loan secured by the borrower's home, with its own issues and risks.
Here, then, are some of the basics about lines of credit.
- A line of credit is a flexible loan from a financial institution that consists of a defined amount of money that you can access as needed and repay either immediately or over time.
- Interest is charged on a line of credit as soon as money is borrowed.
- Lines of credit are most often used to cover the gaps in irregular monthly income or finance a project whose cost cannot be predicted up front.
What Is a Line of Credit?
A line of credit is a flexible loan from a bank or financial institution. Similar to a credit card that offers you a limited amount of funds—funds that you can use when, if, and how you wish—a line of credit is a defined amount of money that you can access as needed and then repay immediately or over a prespecified period of time. As with a loan, a line of credit will charge interest as soon as money is borrowed, and borrowers must be approved by the bank, with such approval a byproduct of the borrower’s credit rating and/or relationship with the bank. Note that the interest rate is generally variable, which makes it difficult to predict what the money you borrow will actually end up costing you.
Lines of credit tend to be lower-risk revenue sources relative to credit card loans, but they do complicate a bank’s earning asset management somewhat, as the outstanding balances can’t really be controlled once the line of credit has been approved. They address the fact that banks are not terribly interested in underwriting one-time personal loans, particularly unsecured loans, for most customers. Likewise, it is not economical for a borrower to take out a loan every month or two, repay it, and then borrow again. Lines of credit answer both of these issues by making a specified amount of money available if and when the borrower needs it.
How Line of Credit Works
When a Line of Credit Is Useful
By and large, lines of credit are not intended to be used to fund one-time purchases such as houses or cars—which is what mortgages and auto loans are for, respectively—though lines of credit can be used to acquire items for which a bank might not normally underwrite a loan. Most commonly, individual lines of credit are intended for the same basic purpose as business lines of credit: to smooth out the vagaries of variable monthly income and expenses or to finance projects where it may be difficult to ascertain the exact funds needed in advance.
Consider a self-employed person whose monthly income is irregular or who experiences a significant, often unpredictable delay between performing the work and collecting the pay. While said person might usually rely on credit cards to deal with the cash-flow crunches, a line of credit can be a cheaper option (it typically offers lower interest rates) and offer more-flexible repayment schedules. Lines of credit can also help fund estimated quarterly tax payments, particularly when there is a discrepancy between the timing of the “accounting profit” and the actual receipt of cash.
In short, lines of credit can be useful in situations where there will be repeated cash outlays, but the amounts may not be known upfront and/or the vendors may not accept credit cards, and in situations that require large cash deposits—weddings being one good example. Likewise, lines of credit were often quite popular during the housing boom to fund home improvement or refurbishment projects. People would frequently get a mortgage to buy the dwelling and simultaneously obtain a line of credit to help fund whatever renovations or repairs were needed.
Personal lines of credit have also appeared as part of bank-offered overdraft protection plans. While not all banks are particularly eager to explain overdraft protection as a loan product (“It’s a service, not a loan!”), and not all overdraft protection plans are underpinned by personal lines of credit, many are. Here again, though, is an example of the use of a line of credit as a source of emergency funds on a quick, as-needed basis.
There is always a credit evaluation process when you apply to a bank for a line of credit.
The Problems with Lines of Credit
Like any loan product, lines of credit are potentially both useful and dangerous. If investors do tap a line of credit, that money has to be paid back (and the terms for such paybacks are spelled out at the time when the line of credit is initially granted). Accordingly, there is a credit evaluation process, and would-be borrowers with poor credit will have a much harder time being approved.
Likewise, it’s not free money. Unsecured lines of credit—that is, lines of credit not tied to the equity in your home or some other valuable property—are certainly cheaper than loans from pawnshops or payday lenders and usually cheaper than credit cards, but they’re more expensive than traditional secured loans, such as mortgages or auto loans. In most cases the interest on a line of credit is not tax deductible.
Some banks will charge a maintenance fee (either monthly or annually) if you do not use the line of credit, and interest starts accumulating as soon as money is borrowed. Because lines of credit can be drawn on and repaid on an unscheduled basis, some borrowers may find the interest calculations for lines of credit more complicated and be surprised at what they end up paying in interest.
Comparing Lines of Credit to Other Types of Borrowing
As suggested above, there are many similarities between lines of credit and other financing methods, but there are also important differences that borrowers need to understand.
Like credit cards, lines of credit effectively have preset limits—you are approved to borrow a certain amount of money and no more. Also, like credit cards, policies for going over that limit vary with the lender, though banks tend to be less willing than credit cards to immediately approve overages (instead, they often look to renegotiate the line of credit and increase the borrowing limit). Again, as with plastic, the loan is essentially preapproved, and the money can be accessed whenever the borrower wants, for whatever use. Lastly, while credit cards and lines of credit may have annual fees, neither charge interest until there is an outstanding balance.
Unlike credit cards, lines of credit can be secured with real property. Prior to the housing crash, home equity lines of credit (HELOCs) were very popular with both lending officers and borrowers. While HELOCs are harder to get now, they are still available and tend to carry lower interest rates. Credit cards will always have minimum monthly payments, and companies will significantly increase the interest rate if those payments are not met. Lines of credit may or may not have similar immediate monthly repayment requirements.
Like a traditional loan, a line of credit requires acceptable credit and repayment of the funds and charges interest on any funds borrowed. Also like a loan, taking out, using, and repaying a line of credit can improve a borrower’s credit score.
Unlike a loan, which generally is for a fixed amount for a fixed time with a prearranged repayment schedule, a line of credit has both more flexibility and, generally, a variable rate of interest. When interest rates rise, your line of credit will cost more, not the case with a loan at fixed interest. There are also typically fewer restrictions on the use of funds borrowed under a line of credit. A mortgage must go toward the purchase of the listed property, and an auto loan must go toward the specified car, but a line of credit can be used at the discretion of the borrower.
Payday and Pawn Loans
There are some superficial similarities between lines of credit and payday and pawn loans, but that is really only due to the fact that many payday or pawn loan borrowers are “frequent flyers” who repeatedly borrow, repay, or extend their loans (paying very high fees and interest along the way). Likewise, a pawnbroker or payday lender does not care what a borrower uses the funds for, so long as the loan is repaid and all its fees are remitted.
The differences, however, are considerable. For anyone who can qualify for a line of credit, the cost of funds will be dramatically lower than for a payday or pawn loan. By the same token, the credit evaluation process is much simpler and less demanding for a payday or pawn loan (there may be no credit check at all), and you get your funds much, much more quickly. It is also the case that payday lenders and pawnbrokers seldom offer the amounts of money often approved in lines of credit. And on their side, banks seldom bother with lines of credit as small as the average payday or pawn loan.
The Bottom Line
Lines of credit are like any financial product—neither inherently good nor bad. It’s all in how people use them. On one hand, excessive borrowing against a line of credit can get somebody into financial trouble just as surely as spending with credit cards. On the other hand, lines of credit can be cost-effective solutions to month-to-month financial vagaries or executing a complicated transaction such as a wedding or home remodeling. As is the case with any loan, borrowers should pay careful attention to the terms (particularly the fees, interest rate, and repayment schedule), shop around, and not be afraid to ask plenty of questions before signing.