Lines of Credit: The Basics And How Lines of Credit Work

Planning a home project or some unexpected car maintenance expenses?  Lines of Credit could be what you need to take up those or other big costs.

What is a Line of Credit?

A line of credit is a flexible loan or a preset amount of money which a bank or credit union has agreed to borrow you. A borrower can draw from the line of credit when the need arises, up to the maximum amount. However, you will pay interest on the amount you borrow.

A line of credit is offered by lenders like banks or credit unions, and if you qualify, you can draw on it up to a maximum amount for a specified period of time.

You are only required to pay interest when you borrow on the line of credit. Immediately you pay back the borrowed funds, that amount again becomes available for you to borrow. There’s flexibility with lines of credit because you choose when to take out the money, pay it back and repeat, for as long as you stick to the terms, plus paying off what you borrow on time and in full.

How Lines of Credit Work

A line of credit gives you access to a set amount of money that you can borrow when you need it. However, you are not required to pay any interest until you actually borrow.

Personal Lines of Credit

Personal lines of credit are typically unsecured. This implies that you don’t need to use collateral to secure the line of credit. Secured lines of credit on the other hand are backed by collateral.

When you apply for a line of credit, you need a better score. This could help you in qualifying for a lower annual percentage rate. Some lines of credit may come with fees like annual fees. As well as limits on the amount that you can borrow.

After qualifying for the line of credit. You’ll have a set time frame known as the “draw period”.  This is a period in which you can draw money from the account. A draw period may last several years. The bank will offer you special checks or a card to use. And also transfer the money to your checking account. Once you are ready to borrow the money.

Note that, once you borrow money from your line of credit, interest usually starts to accrue. And you are required to start making at least the minimum payments, the amount of which will be added back to your available line of credit as you make them. However, when your draw period ends, you’ll enter the repayment period, where you’ll have a set time to pay off any remaining balance. Note however that making only minimum payments may cost you more in interest in the long run.

Business Lines of Credit

A business line of credit is where the financial institution, grants access to a specific amount of financing. It is quite similar to a personal line of credit. A business line of credit can either be secured or unsecured. Often referred to as revolving, lines of credit can be tapped into repeatedly.

Secured Lines of Credit

Home equity is an example of a secured line of credit or HELOC.

HELOCs enable you to borrow against the available equity in your home and uses your home as collateral for a line of credit. HELOCs typically come with a variable interest rate, which implies that your payments may increase over time.

The bank generally limits the amount you borrow to up to 85% of your home’s appraised value, minus the balance left on your first mortgage. Banks will use your credit scores, credit history as well as income in setting your interest rate.

Where you are not a homeowner or don’t want to use your house as collateral, you may be able to take out a line of credit that’s secured against a savings account or certificate of deposit.

However, the disadvantage of a secured line of credit is that, if you can’t make the payments, the lender may take the asset that you used in securing the line.

Unsecured Lines of Credit

If you default on an unsecured line of credit, you may not lose your home or savings. However, the lender will be taking on more risk, which could culminate in higher interest rates as opposed to a secured credit line.

Note that every unsecured line of credit has unique terns. The limits may vary between a few thousand to a few hundred dollars. Also, some lines of credit come with fees.

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