- Posted by: Administrator
- Category: Finance
A credit line is a pool of money available for borrowing. Also known as a line of credit, these loans have a maximum limit, and borrowers have the option of borrowing any amount up to that limit (or not using any of the money at all).
Credit lines are used by individuals, businesses, governments, and other organizations. Whenever flexibility is important — the ability to quickly borrow an unknown or unpredictable amount of money — this type of loan can be helpful.
How do credit lines work?
A credit line is a type of loan, but it is different from basic home and auto loans. If you’re familiar with credit cards, you already understand the basic features of most credit lines.
Borrow when convenient: Once approved, you can generally borrow whenever you need to, and you don’t need to take the money immediately after approval.
Borrow only as much as you need: Credit lines have a maximum borrowing limit. As long as you have not yet borrowed the maximum, you can continue to get money — you don’t need to take the maximum approved amount in one lump sum. Assuming your credit line remains open, you can borrow a small amount today and borrow more next month if needed.
Draw and repayment periods: With most credit lines, you need to make minimum payments after you start borrowing. But you can still borrow and repay repeatedly while you are in the “draw period” (which might last ten years or so). Eventually, some credit lines (such as home equity lines) require you to stop borrowing and repay your debt with standard amortizing payments that eliminate the debt over several years. Credit cards do not have draw and repayment periods — you can borrow and repay continuously.
Examples of Credit Lines
There are several different types of credit lines.
Credit cards are probably the most common example. You start with a zero balance and spend with the card only when you need to. You pay interest on the amount you’re borrowing, and you can always pay off the loan and start borrowing again within the same month.
Home equity lines of credit (HELOCs) allow homeowners to get cash using the equity in their homes. Lenders typically limit the amount you can borrow to 80 percent (or less) of your home’s value.
Business lines of credit provide working capital to small businesses. Because business needs change constantly, it’s not practical to apply for a new loan with every change of season or new customer. A credit line makes borrowing flexible for businesses.
Other types of credit lines exist. Any time borrowers need a flexible way to access cash, banks are up for the challenge.
Compare and Contrast
Contrast a credit line with a standard loan like an auto loan or home loan. With those loans, you only borrow once — when the loan is approved — and you get all of the money that your loan allows up front. There’s no option to come back for more money (you’ll have to apply for a new loan, pay closing costs, and wait for approval).
Standard loans usually come with a flat monthly payment that reduces your balance over time. That’s easy when you know exactly how much the loan will be, how much interest is charged, and when the loan needs to be paid off. But credit lines allow for repeated borrowing and repayment, so level payments don’t work as well (until you enter the repayment period).
Using a Line of Credit
Credit lines are attractive because they’re flexible. You don’t have to apply for a new loan every time you need money. If you expect to borrow multiple times throughout the year, a credit line might be the easiest option. These loans are best for cash-flow management when expenses are unpredictable. They can even be attached to checking accounts to prevent overdraft charges.
How to spend: You’ll often get a checkbook or a payment card that draws from your pool of available funds.
Manage interest costs: Interest charges begin to accrue once you’ve started borrowing. That’s good news if you’re not using your credit line (or if you pay off your debt quickly). This is another advantage over standard loans: You can pay off your debt today and borrow again in a few months if needed.
Use wisely: Credit lines are best used as a safety net to avoid cash flow issues – they’re not the best tool for everyday use or for long-term borrowing. You might have to pay a fee every time you draw on your credit line, and you might find that interest rates are higher than you’d pay for less flexible loans (like a standard mortgage or auto loans with fixed monthly payments).
How to Get a Line of Credit
To get a line of credit, you’ll need to apply, just like you’d apply for any other loan. Lenders will decide whether or not to approve your application (as well as how much to offer) based on normal lending criteria:
- Your borrowing history (for most consumers, your credit scores are used)
- Your income available to repay the loan
- Any assets you pledge as collateral
Collateral is an asset that you use to secure the loan. If you fail to repay the loan according to your lender’s terms, the lender can take that asset, sell it, and use the sales proceeds to get their money back. It’s not uncommon to use your home as collateral for a home equity line of credit.
Borrowing against a home allows you to get approved for large lines of credit at attractive interest rates. However, there’s a significant risk: You might lose your home in foreclosure if you can’t make the payments.
Business owners might find that lenders demand collateral — especially personal assets like the home you live in — to get business lines of credit. It’s better to use business assets like property, equipment, or vehicles, but many businesses don’t have those types of assets.
You might be able to use cash as collateral instead of pledging physical assets like a home or your car. Money in savings accounts and certificates of deposit (CDs) can secure the loan if you borrow from the same bank that holds your savings. You’ll continue earning interest in those accounts and, more importantly, avoid putting your house on the line. This is especially beneficial if you’ll have a zero loan balance for extended periods of time, so it works out best for infrequent borrowing. If you’re paying interest on your credit line, you’re probably paying more than you’ll earn on savings.
It’s also possible to get unsecured lines of credit (a loan is unsecured when you don’t use collateral). However, it is harder to get approved, and you’ll borrow at higher interest rates because the bank is taking more risk when you get an unsecured loan. Again, credit cards are a classic example: They often have high rates, but you don’t need collateral.
Surprises From Your Lender
Unfortunately, you can’t always depend on your line of credit being there when you need it. Banks typically reserve the right to cancel your line of credit or lower your borrowing limit at any time (and that probably won’t happen when it’s convenient for you). As a result, credit lines are problematic: You want them to be there “just in case,” but you need to be prepared for the possibility that your bank will pull the plug at a bad time.