A:

A line of credit (LOC) is a lending arrangement between a financial institution (usually a bank or credit union) and either a business or an individual. A credit account is extended to the borrower with a maximum limit to borrow against. Unlike a mortgage or auto loan the money does not have to be used for a pre-specified purchase. Lines of credit come in both secured and unsecured forms, and there can be significant differences between the two.

Secured Lines of Credit

When a line of credit (or any loan) is secured, it means that the credit grantor has established a lien against an asset that belongs to the borrower. This asset becomes collateral, and it can be seized or liquidated by the lender in the event of default. Perhaps the most common example of this is a home mortgage, in which the bank agrees to lend you a large sum of money against the property itself.

From the lender's perspective, secured lines of credit are attractive because they provide a way to recoup the advanced funds in the event of non-payment. For individuals or business owners, secured lines of credit are attractive, because they typically come with a higher maximum credit limit and significantly lower interest rates than unsecured lines of credit.

One very popular instrument is a home equity line of credit (HELOC). With a HELOC, money is borrowed against either the value of the equity in the home or a second mortgage, each of which establishes a lien position for the creditor.

Unsecured Line of Credit

In an unsecured line of credit, there is no asset is acting as collateral against the lent funds. None of the borrower's major assets are subject to seizure upon default. So the lending institution is assuming a much larger risk.

The additional risk to the creditor makes unsecured lines of credit difficult to approve. They are particularly difficult for businesses that want to open lines of credit for possible capital expansion. In this circumstance, the funds are borrowed against the possibility of future business returns. Lenders usually only consider such a loan to established companies with excellent reputations as debtors.

Lenders attempt to compensate for the increased risk by limiting the amount of funds that can be borrowed and by charging higher interest rates. That's one reason why the APR on credit cards is so high. Credit cards are technically unsecured lines of credit, with the credit limit – how much you can charge on the card – representing its parameters. But you don't pledge any assets when you open the card account, and if you start missing payments, there's nothing the credit card issuer can seize in compensation.

Both secured and unsecured lines of credit have advantages over regular loans: flexibility of purchases, no set monthly payments or regular payment dates (credit cards excepted), no demand to pay the debt in full, and no interest charged on unused credit in the account. If you opt for a revolving credit line, any repayment immediately makes those funds available for credit again, which is useful if you want a long-standing, multifunctional credit account.

See also: "What Is the Difference Between Secured and Unsecured Debts?"

RELATED FAQS
  1. Revolving Credit vs Line of Credit

    Understand how to differentiate between a line of credit and a revolving credit account, their uses, and how both differ ... Read Answer >>
  2. What is the difference between closed-end credit and a line of credit?

    Understand the difference between closed-end credit, open-end credit, and lines of credit. Then find out how each are used ... Read Answer >>
Related Articles
  1. Investing

    Revolving Credit vs. Line of Credit

    Revolving credit and a line of credit are arrangements made between a lending institution and a business or individual.
  2. Personal Finance

    How to Establish Credit with No Credit History

    Even if you have no credit history, taking action to begin establishing your credit history today is a wise move. Learn more in this article.
  3. Personal Finance

    Build Your Credit Score

    Here are four good ways to build your credit score when you're starting from scratch. Do it right and you'll end up with excellent credit.
  4. Personal Finance

    A Good Credit Score: Why Do You Need It?

    Your credit score can affect your ability to borrow money, buy a house or even get a job.
  5. Personal Finance

    Credit Cards to Help You Recover from Poor Credit

    A poor credit score can put a huge damper on your finances. Thankfully using the right credit card can help boost your score and turn around your finances.
  6. Small Business

    How To Increase Your Appeal To Prospective Lenders

    Making a business eligible for loans/credit cards at the best possible rates requires crafting an excellent credit profile through the smart use of credit.
  7. Small Business

    Small Business Loan Vs Line of Credit: How They Differ

    Understand the differences between a small business loan and a line of credit, and learn some of the most appropriate uses for each form of financing.
  8. Personal Finance

    Best Credit Cards For People With Poor Credit Scores

    There are still ways you can build credit with a credit card, even if you have bad credit.
  9. Personal Finance

    6 Ways to Build Credit Without a Credit Card

    Although it's a bit more complicated, it's definitely possible to build a credit history without traditional credit cards.
  10. Personal Finance

    The Importance Of Your Credit Rating

    A great starting point for learning what a credit score is, how it is calculated and why it is so important.
RELATED TERMS
  1. Trade Line

    A trade line is a record of activity for any type of credit extended ...
  2. Credit Utilization Ratio

    The credit utilization ratio is the percentage of a borrower’s ...
  3. Credit Reporting Agency

    A credit reporting agency is a business that maintains historical ...
  4. Unsecured Loan

    An unsecured loan is a loan that is issued and supported only ...
  5. Credit Score

    A credit score is a number ranging from 300-850 that depicts ...
  6. Consumer Credit

    Consumer credit is a debt that someone incurs for the purpose ...
Trading Center