What is a Line of Credit?

How Does a Line of Credit Work?

At its core, a personal line of credit works very similarly to a credit card account. An institution will offer a borrower a defined number of funds that they request, which can be drawn on at any point. In most cases, there is a variable interest rate associated with these borrowed funds. When you draw on your line of credit, the total amount available for borrowing will decrease by that amount.

You can then either continue to draw on the line of credit up until the dollar limit provided by the bank, or you can pay back the funds you’ve borrowed including interest. Once you pay back what you borrowed, the sum total available for borrowing on the line of credit will reset to its full amount. A line of credit differs from a loan in that you only pay interest when you borrow the money, whereas with a loan you pay interest regardless of when you use it.

A unique feature that a personal line of credit has is the fact that after applying and being approved, the borrower and bank agree on a draw period. This draw period is the window for which you can pull funds from the line of credit and can be as long as multiple years.

Where to Find a Personal Line of Credit?

In most cases, a borrower will secure a personal line of credit from a bank. Third party financial institutions that specialize in lending will also offer personal lines of credit, but it’s important to do adequate research beforehand. Some institutions may offer more favorable interest rates or different types of interest rates (fixed vs. variable) that will cost you less over time.

Should you be seeking a personal line of credit, start by researching your primary bank and seeing if the offer this financing solution considering they are aware of your financial history. Additionally, check online to see if you requalify for any personal lines of credit at other banks for better interest rates.

How to Apply for a Personal Line of Credit?

1. Identify the Type of Bills You Have: When you apply for a line of credit, it will need to be for a certain amount. To account for this, ensure that before you apply you figure out the items you will use the line of credit for and what that sum total is.
2. Research Different Sources for Personal Lines of Credit: Don’t settle on the first offer you receive for a line of credit. Do adequate research to ensure you are receiving the best interest rate and offer available.
3. Apply and Get Approved: During the application process you may need to provide information such as your birth name, address, financial information, and more. Have this on hand to expedite the process.
4. Use Your Line of Credit: After being approved, you can use your personal line of credit up to your limit for whatever length of time that is agreed upon.

Different Types of Lines of Credit

As with many other types of financing, there are a number of different types of lines of credit. These include:

• Secured and unsecured lines of credit
• Personal lines of credit
• Revolving lines of credit
• Home equity line of credit

This article has mostly covered personal lines of credit. It’s worth noting that a personal line of credit can be secured, unsecured, or revolving. A revolving line of credit is exactly what we have described above in that a borrower is allowed to draw on the personal line of credit multiple times during its life. A fixed line of credit is when a financial institution only allows you to draw the lump sum of your line of credit once for a specific purpose.

Another type of line of credit is for home equity. This works similarly to a personal line of credit except for the fact that the amount being loaned is secured by having the borrower’s house up as collateral. On that note, let’s dive a little deeper into the difference between secured and unsecured credit.

Unsecured vs. Secured Lines of Credit

When borrowing funds from a financial institution, the credit may either be secured or unsecured. Secured credit is a form of a loan where an institution will offer you the loan in return a security interest of something valuable in the event you can’t pay them back. Auto loans and mortgages are great examples of secured credit, as the loan holder can repossess these items in the event you don’t pay.

Personal lines of credit, credit card accounts, and certain loans are examples of unsecured credit. You will still owe money with interest as a borrower in the event you do not pay, but you did not pledge any other personal assets as collateral for the line of credit.

In general, secured lines of credit or loans tend to have higher principal values and lower interest rates because there is less risk to whoever is loaning the money. On the other hand, unsecured lines of credit and loans will have higher rates and lower principles due to a higher risk.

How a Line of Credit Affects Your Credit Score

As when applying for a credit card, your credit score will be pulled and factored into the decision of whether you should receive a line of credit. This score can also impact the interest rate offered and the amount of credit available for use. With that said, you may be wondering how a personal line of credit will affect your credit.

When you have a line of credit, the sum total of credit available to you is added to your totals from other lines of credit or credit card accounts. This higher amount of credit can help your credit utilization percentage (which essentially counts have much of your total credit you use in a billing cycle). In most cases, a lower credit utilization percentage reflects better on your overall credit score.

By making on-time payments on your line of credit, your payment history will also improve. On top of that, having a longstanding line of credit can increase the length of your credit history which is another factor used in calculating credit score. In short, a personal line of credit affects your credit score in many similar ways to your credit card account. By making on-time payments and keeping your account healthy, your credit score will likely benefit.

Pros and Cons of a Personal Line of Credit

With any form of financing there are pros and cons. A personal line of credit is usually a safe option for receiving access to credit, assuming you are able to make payments on-time and in full. Here are a few pros and cons that may be worth consideration.

Pros

• Quick access to funds when needed
• Strategic use of funds can reduce total interest rate one needs to pay over time
• Flexible lending and refreshment of credit upon repayments

Cons

• Interest is charged the moment you borrow the funds, unlike with a credit card account
• A higher credit score is usually required to receive a significant amount of funds
• Higher interest rates due to being an unsecured form of credit

Personal Line of Credit for Bad Credit

The bottom line is that it is easiest to be approved for a personal line of credit when you have a better credit score. With that said, it is not impossible to receive one with a less than stellar credit history. Keep in mind that you may be given a higher interest rate and what you are allowed to borrow may be smaller than what you hoped.

Personal lines of credit are best for those with stable credit scores and a history of on-time payments. If you don’t have a strong history with credit, it may be better to consider alternative options such as peer-to-peer lending or a credit card that has a low APR or no APR for one year. Additionally, consider looking into receiving a one-time personal loan for your expense so you are not tempted to draw on the line of credit and unable to pay it back later.

FAQs/Commonly Asked Questions About Personal Loans

How hard is it to get approved for a personal line of credit?

Since a personal line of credit is an unsecured form of credit, lenders typically like to see credit scores above 700 ideally. This is not strictly required, however, and scores between 600-699 will likely be considered as well. In general, the stronger you are financially, the better chance you have at being approved for a personal line of credit.

What credit score do you need to get a line of credit?

It is best to aim for a credit score over 600 when trying to secure a personal loan. A score above 700 is ideal, but not probable for everyone. When applying for a line of credit with a score on the lower end of the spectrum, it’s possible that you will be offered a lower borrow amount at a higher interest rate.