- A credit line is a flexible funding option offered at financial institutions for revolving access to cash.
- Your credit score will determine eligibility and how much credit you qualify for.
- HELOCs are the most common type of credit line, but there are also personal or business lines of credit.
When you're borrowing money, it's good to shop around for the best option. For large purchases, you may look for a personal loan. For smaller, everyday purchases, you might want more flexibility in how you spend and pay them off. For that, looking into a line of credit might be worth your time.
What is a line of credit?
A line of credit, also known as a credit line, is a type of revolving credit. It's an amount of money extended to you by a financial institution, such as a bank, that you can draw from when needed.
The difference between a line of credit and a loan
A credit line differs from a loan because you can draw upon any amount up to a certain limit at any time instead of receiving a lump sum that you gradually pay off as you would with a loan. So, if you have a $10,000 credit line, you can draw upon $5,000 for a new home repair project when you need it while still having $5,000 left on your line of credit. If you pay off the borrowed money, your limit will go back to $10,000.
Key characteristics of a line of credit
There are several ways you can access your line of credit funds. Some lenders will give their borrowers special checks that draw from their line of credit once cashed. Some lines of credit will require borrowers to manually transfer money from their line of credit into their bank accounts. Others simply give you a card to use, like a credit card. Once you draw from the funds available, you'll start accruing interest on the borrowed amount.
As you pay back what you borrowed, your available credit will increase. A line of credit can offer more flexibility in the amount you borrow and what you have access to compared to a traditional installment loan.
Line of credit vs. credit card
All credit cards are lines of credit; however, not all lines of credit are credit cards.
Lines of credit and credit cards differ in how much you'll be paying and how much you'll be getting in return. Credit cards generally have higher APRs than other lines of credit, which means you'll be paying more to use a credit card than a line of credit. However, you can earn points or other perks when using a rewards credit card.
Lines of credit also tend to have higher credit limits than credit cards, so you can use more before worrying about how it will affect your credit utilization ratio.
Another key difference between the two comes down to flexibility. While lines of credit offer more freedom than a personal loan, they're still more rigid than credit cards. This is because lines of credit have a time limit to borrow money, known as a draw period. These will differ based on the type of credit line you choose, but you'll have a few years to borrow money. You'll still have to make minimum payments during your draw period, but these will be small, usually just enough to cover any interest accrued.
Once the draw period ends, the credit line will enter a repayment period. In this period, your remaining balance on the line of credit turns into an amortized loan that you'll start paying off. You will also no longer be able to borrow additional money through that credit line.
Types of lines of credit
There are various types of credit lines that you may be eligible for, including secured and unsecured credit lines. Secured credit lines are backed by an asset, such as a car or home, which serves as collateral. Some banks that offer brokerage services may also allow you to use your investments as collateral. On the other hand, unsecured credit lines aren't backed by any collateral, e.g., most credit cards.
Home equity line of credit (HELOC)
One popular line of credit is a home equity line of credit, more commonly known as a HELOC. Using a HELOC, homeowners can borrow funds against the equity from the home, meaning the amount of the home's value that you own. If you're still paying a mortgage, you can borrow against what you've already paid off.
HELOCs usually have a draw period of 10 years, at which point you enter the repayment period; some HELOCs require you to settle your debts at the end of the draw period. Some HELOCs will require you to take out a minimum amount upfront.
Because your home value secures your line of credit, you won't need as high of a credit score to qualify. You'll usually be able to borrow up to 85% of your home's equity.
Personal line of credit
Other types of unsecured lines of credit, such as personal lines of credit, don't have any assets to serve as collateral but may have fees, though there may be an annual fee or upfront costs to access the line of credit. You might want to use one to pay for school expenses or car maintenance costs or fund a business-related project — so long as you know you can repay the loan.
Draw periods on personal lines of credit are typically shorter than those on HELOCs.
Business line of credit
Like other lines of credit, a business line of credit offers greater flexibility than its loan counterpart. A small business loan will give a business owner a lump sum of money they'll have to pay off gradually. Meanwhile, a business line of credit will allow business owners to pay for expenses as they arise. Keep in mind that a business line of credit will also be more expensive than a business loan.
Benefits and risks of using a line of credit
Benefits of using a line of credit
- Interest payments: Unlike a traditional loan, you only pay interest on the money you use rather than on the entire loan amount.
- Flexibility: A personal line of credit usually has a long time period in which you can use it, often a few years. That means you can access the money any time you need it.
- Balance replenishes: When you repay the money by a certain time, it becomes available to borrow again.
- Financial use: The money from a personal line of credit can be used for almost anything, so it can be a good way to pay off higher-interest debt.
Things to consider when using a line of credit
- Interest rates: A personal line of credit may have a higher interest rate than other financial products, such as a loan.
- Fees: Most personal lines of credit come with fees, such as an annual or monthly maintenance fee and a transaction fee, which is charged every time you borrow money.
- Credit score: Because a personal line of credit is unsecured, people with a low credit score may have difficulty qualifying for one or getting favorable rates.
How to qualify for a line of credit
Getting a line of credit is relatively simple. You go to your bank of choice and apply for one. However, there are several things you should consider during the process.
1. Credit score and income requirements
Each lender will have their own credit and income requirements for approving you for a line of credit. Before applying for a credit line with a bank, you want to know where you stand, credit-wise. You can check your credit report at AnnualCreditReport.com. The information in your credit report is used to calculate your credit score, so you want to make sure everything looks correct. If there are errors, you can file a dispute to fix them.
You can also sign up for a credit monitoring service, which will give you access to your credit score and keep you updated on any changes to your report.
2. Shop around
Once you know your credit score, you can apply for a line of credit at a financial institution, such as a bank or credit union. Shop around for the best rates and check out any limits and eligibility requirements, specifically regarding your credit score. You typically want at least a good credit score (670 or higher) when applying for an unsecured personal line of credit or a HELOC. You can get a line of credit for several thousand dollars up to $50,000 if your credit score qualifies you for it.
When comparing credit lines, you will want to focus on the terms of agreement each financial institution offers. Compare credit limits, annual fees, and APRs.
You will also want to look at how long your draw period is and how you will be expected to pay after it ends. Some plans ask that you pay it all back at the end of the draw period, also called a balloon payment, which changes how you borrow. Some plans will also require that you borrow a certain amount from your credit line upfront.
3. Apply for a credit line
Once you've made a decision, you'll have to submit a credit application.
When reviewing your application, a lender will pull a hard inquiry on your credit, giving them access to your credit history. This will show up on your credit report and will lower your score temporarily. Once approved, the financial institution will approve you for a specific amount and have a draw period in which you can use money from your credit line. The draw period can vary but may last up to several years.
Interest will start to accrue after borrowing from the credit line and you'll begin to make payments. As you pay back the credit line, your available credit from your credit line will increase.
4. Use your line of credit
Once you have your line of credit, you can start borrowing according to the rules established by your lender. Depending on your credit line, you may have to take out a minimum payment upfront.
Remember the terms you agreed to when you signed off on your credit line. Most lenders don't have restrictions on what you spend your money on. Regardless, you shouldn't spend too freely, especially if a balloon payment is waiting for you at the end of your draw period.
Frequently asked questions about a line of credit
Limits on personal lines of credit can usually be as high as $50,000. Your credit limit on a HELOC will depend on the value of your house.
A line of credit can affect your credit score just like any other credit product. Applying for a line of credit will result in a hard inquiry on your credit report, the new credit will impact your utilization, and how diligently you pay your bill will impact your payment history.
You can qualify for a line of credit with bad credit, but it's harder. If you have a bad credit score, below 670, you may encounter difficulties when applying for a line of credit. Lending standards for HELOCs are slightly looser, especially for homeowners with valuable homes.
