What is a Line of Credit (LOC)
A line of credit (LOC) is an arrangement between a financial institution – usually a bank – and a customer that establishes the maximum loan amount the customer can borrow. The borrower can access funds from the line of credit at any time as long as they do not exceed the maximum amount (or credit limit) set in the agreement and meet any other requirements such as making timely minimum payments.
How Line of Credit Works
BREAKING DOWN Line of Credit (LOC)
A line of credit has built-in flexibility, which is its main advantage. Borrowers can request a certain amount, but they do not have to use it all. Rather, they can tailor their spending on the LOC to their needs and owe interest only on the amount they draw, not on the entire credit line. In addition, borrowers can adjust their repayment amounts as needed, based on their budget or cash flow. They can repay, for example, the entire outstanding balance all at once or just make the minimum monthly payments.
Why a Line of Credit (LOC) Is a Revolving Account
A line of credit is a type of revolving account, also known as an open-end credit account. This arrangement allows borrowers to spend the money, repay it and spend it again in a virtually never-ending, revolving cycle. Revolving accounts such as lines of credit and credit cards are different from installment loans such as mortgages, car loans and signature loans. With installment loans, also known as closed-end credit accounts, consumers borrow a set amount of money and repay it in equal monthly installments until the loan is paid off. Once an installment loan has been paid off, consumers cannot spend the funds again unless they apply for a new loan.
Unsecured LOCs vs. Secured LOCs
Most lines of credit are unsecured loans. This means the borrower doesn't promise the lender any collateral to back the LOC. One notable exception is a home equity line of credit (HELOC), which is secured by the equity in the borrower's home. Unsecured lines of credit tend to come with higher interest rates than secured LOCs. They are also more difficult to obtain and often require a higher credit score.
- A line of credit has built-in flexibility, which is its main advantage.
- Unlike a closed-end credit account, a line of credit is an open-end credit account, which allows borrowers to spend the money, repay it and spend it again in a never-ending cycle.
- While a credit line’s main advantage is flexibility, potential downsides include high interest rates, severe penalties for late payments, and potential to overspend.
How Credit Lines Work
All LOCs consist of a set amount of money that can be borrowed as needed, paid back and borrowed again. The amount of interest, size of payments and other rules are set by the lender. Some lines of credit allow you to write checks (drafts) while others include a type of credit or debit card. As noted above, an LOC can be secured (by collateral) or unsecured, with unsecured LOCs typically subject to higher interest rates.
Examples of Lines of Credit
LOCs come in a variety of forms, with each falling under either the secured or unsecured category. Beyond that, each type of LOC has its own characteristics.
Personal Lines of Credit provide access to unsecured funds that can be borrowed, repaid and borrowed again. Opening a personal line of credit requires a credit history of no defaults, a credit score of 680 or higher and reliable income. Having savings helps, as does collateral in the form of stocks or CDs, though collateral isn’t required for a personal LOC. Personal LOCs are used for emergencies, weddings and other events, overdraft protection, travel and entertainment and to help smooth out bumps for those with irregular income.
Home Equity Lines of Credit (HELOCs) are the most common type of secured LOCs. A HELOC is secured by the market value of the home minus the amount owed, which becomes the basis for determining the size of the line of credit. Typically, the credit limit is equal to 75% or 80% of the market value of the home minus the balance owed on the mortgage. HELOCs often come with a draw period (usually 10 years) during which the borrower can access available funds, repay them and borrow again. After the draw period, the balance is due, or a loan is extended to pay off the balance over time. HELOCs typically have closing costs including the cost of an appraisal on the property used as collateral. Following passage of the Tax Cuts and Jobs Act of 2017, interest paid on a HELOC is only deductible if the funds are used to buy, build or substantially improve the property that serves as collateral for the HELOC.
Demand Lines of Credit can be either secured or unsecured, but they are rarely used. With a demand LOC the lender can call the amount borrowed due at any time. Payback (until the loan is called) can be forestalled, interest-only or interest plus principal, depending on the terms of the LOC. The borrower can spend up to the credit limit at any time.
Securities-Backed Lines of Credit (SBLOCs) are special secured-demand LOCs, in which collateral is provided by the borrower’s securities. Typically, an SBLOC lets the investor borrow anywhere from 50% to 95% of the value of assets in his or her account. SBLOCs are non-purpose loans, meaning the borrower may not use the money to buy or trade securities. Almost any other type of expenditure is allowed. SBLOCs require the borrower to make monthly, interest-only payments until the loan is repaid in full or the brokerage or bank demands payment, which can happen if the value of the investor’s portfolio falls below the level of the line of credit.
Business Lines of Credit provide a way for a business to borrow on an as-needed basis instead of taking out a fixed loan. The financial institution extending the LOC evaluates the market value, profitability and risk taken on by the business and extends a line of credit based on that evaluation. The LOC may be unsecured or secured, depending on the size of the line of credit requested and the evaluation results. As with almost all LOCs, the interest rate is variable.
Problems with Lines of Credit
The main advantage of a line of credit is the ability to borrow only the amount needed and avoid paying interest on a large loan. That said, borrowers need to be aware of potential problems when taking out a line of credit.
- Unsecured LOCs have higher interest rates and credit requirements than those secured by collateral.
- Interest rates (APRs) for lines of credit are almost always variable and vary widely from one lender to another.
- Lines of credit do not provide the same regulatory protection as credit cards. Penalties for late payments and going over the LOC limit can be severe.
- An open line of credit can invite overspending, leading to an inability to make payments.
- Misuse of a line of credit can hurt a borrower’s credit score.