What Is A Line Of Credit?
There are many different types of financing, and among them are lines of credit. A line of credit (LOC) represents a financing type with a maximum fixed amount that you can borrow at any time from a lender. In case of an open line of credit, you can borrow as many times as you want, if you regularly make repayments towards the debt.
Keep reading to explore the line of credit definition and how it can be a potential financing tool to suit your needs.
What Are Credit Lines?
So, what is a line of credit and how does it impact you? A line of credit is a type of revolving debt where instead of receiving a lump sum amount, you can regularly borrow up to a limit when needed and repay the amount with interest before borrowing again up to the limit. When you borrow through a line of credit, the lender decides the principal amount, interest rates, and other terms.
You can potentially secure this type of debt by backing up the loan amount with collateral. In the case of the unsecured equivalent, the interest rates are on the higher side. As a borrower, even if you borrow a certain amount, but do not spend it entirely, you owe interest only on the amount you have borrowed and not on the whole credit line.You also have the flexibility of making payments based on your cash flow or budget. You can either pay minimum monthly payments or clear the entire outstanding amount at once. Flexibility is one of the biggest advantages of lines of credit.
Secured Vs. Unsecured LOCs
Most LOCs are unsecured loans where borrowers don’t offer collateral to back up the loan amount. A HELOC (home equity line of credit) is an exception given the equity in the borrower's home secures the loan. For individuals and businesses, secured versions of this debt may be preferable because they offer higher credit limits and lower interest rates when compared to unsecured versions.
For lenders, secured loans are more desirable given they have the security of recovering the money in the event of non-payment.If you are looking for unsecured revolving debt, you must have a good credit rating with a high score. Lenders usually limit their own risk by charging higher interest rates and limiting the amount of money issued to the borrowers. Credit cards are a good example of unsecured debt, which is why the interest rates on them are generally higher.
Revolving Vs. Non-Revolving Lines Of Credit
A line of credit is a revolving account that is also considered as an open-ended credit account. You can borrow, spend, repay, and borrow again in an ongoing cycle. Credit cards are common examples of revolving credit.
With non-revolving credit, or loans, you can borrow a fixed amount and continue to clear it through fixed monthly payments. The credit pool does not refill, so the account gets closed once you clear the debts.
Home loans, auto loans, and personal loans are common examples of non-revolving credit. If you need additional funds, you need to make fresh applications.
Examples Of Lines Of Credit
This type of debt comes in different forms and falls under two broad categories: secured and unsecured LOCs. Apart from this, each type features unique characteristics that define its structure.
Personal Line Of Credit
If you want to open a personal LOC, you must have a stable income, a credit score of 680 or above, and a history of no defaults. This unsecured credit can be used to borrow, spend, repay, and borrow again. Personal LOCs are ideal for weddings, emergencies, travel, leisure, overdraft protection, and more.
Home Equity Line Of Credit (HELOC)
A HELOC is a popular secured line of credit that is protected by the market value of a property. The draw period for HELOCs is usually around 10 years during which you can spend, repay, and borrow again. HELOCs usually involve closing costs, which includes the appraisal cost of the property that is used as collateral.
Demand Line Of Credit
This is a less common form of revolving debt that is either secured or unsecured. Lenders have the authority to recall the amount borrowed whenever they want. As a borrower, you can spend up to the credit limit.
Securities-Backed Line Of Credit (SBLOC)
With a SBLOC, you must provide collateral through your invested securities. This lets the investor borrow between 50-95% of the value of securities available in their investment portfolio. These are non-purpose loans, so you may not use the borrowed sum for buying or trading securities. You must ensure to pay interest-only payments on a monthly basis until the time you are able to repay the loan in full.
Business Line Of Credit
Business LOCs are useful for businesses that require funds based on their needs without the need to borrow a fixed amount. Lenders consider factors like profitability, market value, and risk involved before lending money to a business. A BLOC can be either secured or unsecured based on the amount and the evaluation results. The interest rates are variable here just like most other LOCs.
Limitations Of Lines Of Credit
This debt type grants you the flexibility to borrow only what you require. You have to pay back only the amount borrowed and not the entire credit line. Still, there are certain limitations which you must keep in mind.
- You must have a good credit score and credit history if you want unsecured credit.
- The regulatory protection for LOCs is not the same as with credit cards. If you default on payments, you will invite harsh penalties.
- Interest rates are always variable and will differ from lender to lender.
- You may be tempted to overspend if you have an open line of credit like a credit card. Your chances of defaulting on payments increase with overspending.
- If you mishandle LOCs, your credit score can be negatively affected.