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.