What is a line of credit?

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In a Nutshell

A line of credit is a preset amount of money that a financial institution like a bank or credit union has agreed to lend you. You can draw from the line of credit when you need it, up to the maximum amount. You’ll pay interest on the amount you borrow.
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A line of credit gives you access to money “on demand” and can help you with expenses like a home project or unexpected car maintenance.

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

You’ll pay interest only when you borrow on the line of credit. Once you pay back borrowed funds, that amount is again available for you to borrow. Flexibility is the key here: You can choose when to take out the money, pay it back and repeat — as long as you stick to the terms, including paying off what you borrow on time and in full.

Read on to learn how lines of credit work and when one could be a good option for you.

How do lines of credit work?

First, let’s talk about the options you have when you need to borrow money. Broadly speaking, you can usually apply for either a loan or a line of credit. With a loan, you get one lump sum of money and start paying interest immediately, regardless of when you use the money.

By contrast, a line of credit gives you access to a set amount of money that you can borrow when you need it. But you don’t pay any interest until you actually borrow.

There are business lines of credit, but we’ll look at lines of credit for personal use here.

Personal lines of credit are usually unsecured, meaning you don’t need to use collateral to take out the line of credit. Secured lines of credit are backed by collateral, such as your house or a savings account.

When you apply for a line of credit, having better credit scores could help you qualify for a lower annual percentage rate. Some lines of credit may come with fees, such as an annual fee, and limits on the amount you can borrow.

After you qualify for the line of credit, you’ll have a set time frame — known as the “draw period” — in which you can draw money from the account. A draw period can last several years. The bank may give you special checks or a card to use, or transfer the money to your checking account, when you’re ready to borrow the money.

Once you borrow money from your line of credit, interest usually starts to accrue and you’ll have 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. But once your draw period ends, you’ll enter the repayment period, in which you’ll have a set time to pay off any remaining balance. Keep in mind, making only minimum payments may cost you more in interest in the long run.

How will a line of credit impact my credit scores?

As part of the application process for a line of credit, the lender may perform a hard inquiry on your credit reports. This could temporarily lower your credit scores by a few points.

After you’re approved and you accept the line of credit, it generally appears on your credit reports as a new account.

If you never use your available credit, or only use a small percentage of the total amount available, it may lower your credit utilization rate and improve your credit scores. Your utilization rate represents how much of your available credit you’re using at a given time. If you borrow a high percentage of the line, that could increase your utilization rate, which may hurt your credit scores.

Also, your credit health may suffer if you make late payments.

Secured lines of credit

One option if you’re looking to take out a secured line of credit is a home equity line of credit, or HELOC.

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

Generally, the bank will limit the amount you can borrow to up to 85% of your home’s appraised value, minus the balance remaining on your first mortgage. When banks set your interest rate, other factors besides your credit scores come into play, including your credit history and income.

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

The downside for a secured line of credit? If you can’t make the payments, the lender may take the asset that secured the line.

Unsecured lines of credit

You may not stand to lose your home or savings if you default on an unsecured line of credit. But the lender is taking on more risk with unsecured loans, which could lead to higher interest rates than with a secured line.

Every unsecured line of credit has unique terms. The limits may range between a few thousand to a few hundred thousand dollars. Some lines of credit come with fees — for example, you might have to pay an annual fee just to keep the account open.

What’s the difference between a credit card and a line of credit?

Credit cards are similar to lines of credit. Both are a revolving line of credit, which means you can draw money from it up to the credit limit, then repay it (plus any interest you owe), and borrow it again.

But credit cards and lines of credit are two different products that are offered by lenders, and there are some key differences between them.

With credit cards, you won’t have a draw period — you can use the card for as long as the account is open and in good standing. Many come with rewards programs, and if you can pay off your balance on time and in full each month and your card has a grace period, you may avoid paying interest altogether. This means that credit cards may be a better choice for everyday spending, if used responsibly.

The downside to credit cards: They may come with higher interest rates than lines of credit, so keeping a balance on one may cost you more. They may also offer lower limits than personal lines of credit, and you could face high fees and APRs if you want to actually take out cash with a cash advance from a credit card.

Tips for using a line of credit

Before you take out a line of credit — secured or unsecured — check your credit scores and take steps to boost your credit health so that you can improve your chances at qualifying for a lower interest rate. Then figure out how much you need and how you plan to spend the money.

If you need a flexible way to access money, it may be a good idea to ask for a line of credit, says Bruce McClary, vice president of communications at the National Foundation for Credit Counseling®.

But, he adds, “if you’re borrowing because you’re trying to avoid getting into financial trouble with another loan … there’s a deeper issue that needs to be resolved that can’t be addressed by continuing a cycle of borrowing.”

Here are some guidelines for when to use — or not use — a line of credit.

When not to use a line of credit

  • If you know you can’t afford payments or your income is unstable, a line of credit might not be a good choice. If you default on payments, your credit will most likely suffer. What’s more, on a secured line of credit, the lender may take possession of the collateral.
  • If you know exactly how much you need and you don’t want to use collateral, you may be able to find an unsecured personal loan with better rates than an unsecured line of credit, depending on your credit.
  • If you’re using the line of credit for basic needs, or to fund short-term expenses like dining out and vacations, that could be a red flag that you’re struggling financially and shouldn’t take out new debt.

When to use a line of credit

  • If you need the money for a home-improvement project, education costs or other types of major expenses, a HELOC or secured line of credit may be a good idea — as long as you know you’ll have the money for repayment. Bonus: The interest you pay on the HELOC may be tax-deductible.
  • An unsecured personal line of credit may help you consolidate several small debts you’re paying off into one payment with a lower APR, while avoiding using collateral (depending on the terms of each line of credit and your creditworthiness).

About the author: Kim Porter is a writer and editor who has written for AARP the Magazine, Credit Karma, Reviewed.com, U.S. News & World Report, and more. Her favorite topics include maximizing credit card rewards and budgeting. Wh… Read more.