What is a line of credit?

How do lines of credit work?

A line of credit is technically a loan — but, unlike with a traditional personal loan, you only pay interest on the amount of money you use. When you’re approved for a line of credit, the lender agrees to give you access to a specified amount of money. You can spend as much of the maximum amount as you’d like. Once you pay it back, the amount of credit you have adjusts accordingly. This is known as “revolving credit.”

With a line of credit, you only pay interest on what you borrow, even if the money you’re approved for exceeds this amount.

As an example, say you have a $25,000 line of credit to help you remodel your home. You use $4,000 on an initial expense. You would then owe back $4,000 plus interest, and you would have $21,000 remaining on the line of credit. Once you pay back the principal, it would add back on to the line of credit.

Depending on how the lender structures the line of credit, you may have a draw period that lasts from five to 15 years, followed by a repayment period of equal length where you can no longer borrow and must pay off the debt.

To get a line of credit, a borrower must be approved by the lender. Approval usually depends on the applicant's credit score, credit history, employment, income and current debts.

Line of credit uses

Typically, a line of credit isn't intended to fund a significant one-time purchase like a car or a down payment on a home. This type of loan works best when the total cost of a project is somewhat undefined and you might need to withdraw funds a handful of times throughout the course of a few years. Having a line of credit can help you avoid taking out multiple personal loans and give you greater overall flexibility.

If you need to smooth out irregular income from a seasonal business, want access to funds for emergency use, are remodeling your home or need robust overdraft protection, a line of credit might be a good fit for you.

Line of credit vs. loan

With a loan, you typically receive a lump sum and have a fixed amount of time to pay it back (plus interest and fees). A line of credit lets you take out up to a certain amount of money at any given time, but you only pay interest on the portion of the money they withdraw.

A line of credit usually has a variable interest rate, while a personal loan tends to have a fixed interest rate.

A line of credit often has a variable interest rate that adjusts according to market conditions. When interest rates are high, the cost of accessing money in a line of credit increases. In most cases, personal loans have fixed interest rates, so the borrower's monthly payment stays the same throughout the term of the loan.

Whether you’re trying to get a line of credit or a loan, your lender will collect your personal information and look at your credit history to evaluate how much of a risk you pose. Applicants with excellent credit pay less interest than those with credit problems or no credit history.

The process of getting approved for a line of credit is similar to applying for a loan and may take about the same amount of time, depending on the lender. Keep in mind: If you’re considering a line of credit to help cover dips in income or to assist with financial emergencies, opening one before you need it means you'll have immediate access to funds when you need them.

Unsecured vs. secured line of credit

With an unsecured line of credit, there is no collateral, so the lender can’t take any of your assets if you default. For this reason, you may have a tougher time getting approved if you don’t have a good credit score.

A secured line of credit might give you access to more funds and a lower interest rate.

Secured lines of credit require collateral, which the lender can take if you fail to repay the loan. A home equity line of credit (HELOC), for instance, uses your home as collateral; if you fail to pay back the loan as agreed, the lender could start the foreclosure process.

One advantage to a HELOC is that you may be able to deduct the interest on your taxes if you use the money to improve your home — consult a tax expert so you understand how deductions may apply to your situation.

With a secured line of credit, the lender may be more flexible when it comes to approving your loan application because the loan is backed by collateral. You may also pay less interest with a secured line of credit than you would with an unsecured line of credit.

What to consider before taking out a line of credit

Like other loan types, a line of credit can be a useful financial tool. You only borrow and pay interest on the money you need, unlike with a personal loan. And the interest rate on a line of credit is usually lower than on a credit card, another form of revolving credit. Lenders offer both unsecured and secured lines of credit and let you use the funds for many purposes.

Lines of credit do have some drawbacks. Because the interest rate is usually variable, it can be difficult to predict future borrowing costs. Lenders may charge a variety of fees. Also, the easy access to credit once you open the line of credit may lead to overspending.

If you understand how a line of credit works and use it appropriately, it could be the right type of loan for you. A Nebraska resident who left a review on ConsumerAffairs appreciated how quickly she was able to access funds.

“Once approved I requested the amount needed for my line of credit. I requested some money on a Friday and had my cash by Monday," they said. "Keep in mind this credit is going to cost me, but the rates and fees are clear if you read them.”

Bottom line

A line of credit can be a powerful tool to help you reach your goals if you have good credit but deal with irregular income, want access to funds in case there's a financial emergency or want to start a project and are unsure of the total costs. However, like any type of credit, a line of credit can be expensive. Borrowers with bad credit pay high interest rates and are subject to additional costs like account management charges and loan origination fees.

If you’re interested in getting a line of credit, talk with your bank or credit union to see if it offers this type of loan. No matter what type of loan you get, be sure to shop around to get the lowest rates and best terms.