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

    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.
  3. 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.
  4. Personal Finance

    Why and How to Use Credit Cards Effectively

    When used responsibly, credit cards play a big role in establishing a good credit score that can help you obtain loans, mortgages and insurance.
  5. Investing

    Investing in Credit Card Companies

    Find out why investing in credit card companies requires keeping an eye on consumer indexes and the overall health of the economy.
  6. Personal Finance

    Should you increase your credit card limit?

    Understand the fundamentals between credit scores, credit card limit, and your credit utilization rate. Find out why you should ask for your credit limit increase and the benefits that follow.
  7. Personal Finance

    Credit Cards For People With Bad Credit

    Yes, you can get a credit card and start repairing your credit history. But brace yourself for low credit limits, sky-high interest and staggering fees.
  8. Small Business

    How to Use Small Business Credit Cards

    A small business credit card can be a convenient way to increase your company's purchasing power, but must be carefully managed.
  9. Personal Finance

    How Credit Cards Affect Your Credit Rating

    The average American household has four cards, but does that mean more is better?
  10. Personal Finance

    Why You Should Improve Your Credit and How to Do It

    With credit playing a big role in many financial decisions, it is important to maintain good credit.
RELATED TERMS
  1. Credit Card Debt

    Credit card debt is a type of unsecured liability which is incurred ...
  2. Credit Analyst

    A credit analyst is a financial professional who possesses expertise ...
  3. Credit Utilization Ratio

    The credit utilization ratio is the percentage of a borrower’s ...
  4. Credit Card

    Issued by a financial company giving the holder an option to ...
  5. Credit Reporting Agency

    A credit reporting agency is a business that maintains historical ...
  6. Consumer Credit

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