What is a line of credit and how does it work?

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A line of credit, also known as revolving credit, is a set amount of money lent by a financial institution that customers can borrow and pay back as needed. People usually opt for a line of credit (LOC) when they want the flexibility to borrow funds for various needs, without having to apply for multiple loans.

A line of credit is similar to a credit card because you have funds available up to a certain credit limit, and you only pay interest on the amount borrowed. If you need a significantly higher credit line than a credit card will provide, or if you need to borrow cash for big-ticket purchases, a line of credit might be a good choice for you. Before you dive into the application process, it’s important to understand how a line of credit works and how it can affect the state of your credit.

How does a line of credit work?

If you need assistance filling in the gaps of unpredictable monthly income—or paying for a project with a variable cost—a line of credit might be a good option for you.

There are two main types of LOCs: secured and unsecured. A secured line of credit is guaranteed by an asset such as a home or a car, whereas an unsecured line of credit is not backed by any collateral. Here are five steps that outline the general process of how a line of credit works:

1) You contact a bank or credit union to apply for a line of credit. Then, the financial institution processes your application and checks your credit. This type of credit check is known as a hard inquiry.

2) You discuss and agree on a credit limit, interest rate, minimum payment requirements and other stipulations with the financial institution.

3) After your application is approved, you’re granted the line of credit. You can use as much or as little of the credit line on any purchase you could make with cash until the credit limit is reached.

4) You receive a statement that outlines how much you owe, your remaining available credit, your minimum payment amount, your payment due date and more.

5) When you receive your monthly statement, you must partially or fully pay off your balance. If you don't fully pay it off, you carry the balance over to the next month and pay interest on any remaining balance. More of your credit line becomes available as you pay down the balance.

Types of lines of credit

The three types of credit lines made available by financial institutions are personal, business or home equity lines of credit.

• Personal Line of Credit: This type of line of credit can be either secured or unsecured. You can take out a LOC that’s secured against a savings account or certificate of deposit, or you can take out an unsecured LOC, which usually has higher interest rates.
• Business Line of Credit: This revolving credit line provides businesses with flexible, short-term financing. Rather than taking out a fixed loan, business owners use LOCs to borrow funds on an as-needed basis.
• Home Equity Line of Credit: This type of line of credit, also known as a HELOC, allows you to use your house as collateral by borrowing against the available equity in your home. There is usually a variable interest rate, meaning your payments may increase over time.

What is the difference between a loan and a line of credit?

A line of credit allows you to borrow money on an as-needed basis without paying interest until you start borrowing. On the other hand, a loan is a lump sum of money that you immediately pay interest on regardless of when you start using the funds.

If you have a clear borrowing need with a specific purpose—like buying a car—then a loan might be your best bet. However, if you want the flexibility to borrow for a variety of needs, without having to reapply every time, then a line of credit may be a better option for you.

How does a line of credit affect your credit score?

Taking out a line of credit isn’t inherently good or bad for your credit score. Factors that influence your credit score include your credit line utilization and how diligently you repay what you owe. Your utilization rate increases if you’ve borrowed a high percentage of your available credit. Over-utilization of your line of credit could ultimately hurt your credit score.

In the same way that maxing out your credit cards could damage your credit score, using up your line of credit quickly could be detrimental. Whether or not a line of credit affects your credit score comes down to personal responsibility. If you consistently make your payments by the due date, you will build a positive payment history that strengthens your score over time.

Line of credit pros and cons

Before you rush into getting a line of credit, make sure you weigh the pros and cons to be sure it’s the best move. In most cases, a credit card can be just as effective in accomplishing what you would want to do with a line of credit.

Be sure to check the industry averages of what a good line of credit is typically worth, including the interest rate, annual percentage rate (APR) and whether or not there is an annual fee.

Pros:

• Flexibility to fund projects. You can cover major expenses such as home improvement projects, weddings, education costs, etc.
• Better options for withdrawing cash. LOCs allow more spending power than a credit card can provide.
• Competitive rates and minimal fees. Fewer fees are associated with personal LOCs. Interest rates are typically lower than those of credit cards and loans.
• Fewer restrictions. LOCs have much looser guidelines on what they can be used for, unlike student and auto loans.
• Easy-to-access funds. LOCs function similarly to bank accounts. You can draw from them as needed.

Cons:

• Solid credit is needed. Most lines of credit require the applicant to have good credit, and that’s especially true for unsecured LOCs.
• You might damage your credit score. If you default on payments, your chances of hurting your credit score are very high.
• The lender can seize your collateral (e.g., your home). If payments are not adequate on a secured LOC, you might face forfeited assets and a lower credit score.
• Lower credit limits. LOCs tend to have lower limits than loans.
• Potential for higher interest accrued. Lines of credit often have variable interest rates—when rates increase, it can lead to higher payable interest.

Be sure to assess your overall financial health to decide if a line of credit is the right fit for you. Especially during the COVID-19 pandemic, staying on top of your finances is key to setting yourself up for long-term financial stability.

Remember that your credit score is a major factor in determining whether you qualify for a line of credit and what interest rate you can get. If you’re currently not satisfied with your credit score, there are tangible solutions to help you increase it. You can start by getting a free credit report. You can also find resources online or contact a credit repair advisor for personalized help with credit repair.

Sources: Debt.org | Credit.com | FTC Consumer Information | CFPB