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Peggy James is a CPA with 8 years of experience in corporate accounting and finance who currently works at a private university.
What Is a Line of Credit (LOC)?
A line of credit (LOC) is a preset borrowing limit that can be tapped into at any time. The borrower can take money out as needed until the limit is reached, and as money is repaid, it can be borrowed again in the case of an open line of credit.
A LOC is an arrangement between a financial institution—usually a bank—and a client that establishes the maximum loan amount the customer can borrow. The borrower can access funds from the line of credit at any time as long as they do not exceed the maximum amount (or credit limit) set in the agreement.
A line of credit (LOC) is a preset borrowing limit that a borrower can draw on at any time.Types of credit lines include personal, business, and home equity, among others.A LOC has built-in flexibility, which is its main advantage.Potential downsides include high interest rates, severe penalties for late payments, and the potential to overspend.
Understanding Credit Lines
All LOCs consist of a set amount of money that can be borrowed as needed, paid back and borrowed again. The amount of interest, size of payments, and other rules are set by the lender. Some lines of credit allow you to write checks (drafts) while others include a type of credit or debit card. A LOC can be secured (by collateral) or unsecured, with unsecured LOCs typically subject to higher interest rates.
A line of credit has built-in flexibility, which is its main advantage. Borrowers can request a certain amount, but they do not have to use it all. Rather, they can tailor their spending from the LOC to their needs and owe interest only on the amount they draw, not on the entire credit line. In addition, borrowers can adjust their repayment amounts as needed, based on their budget or cash flow. They can repay, for example, the entire outstanding balance all at once or just make the minimum monthly payments.
Unsecured vs. Secured LOCs
Most lines of credit are unsecured loans. This means the borrower does not promise the lenderany collateral to back the LOC. One notable exception is a home equity line of credit (HELOC), which is secured by the equity in the borrower"s home. From the lender"s perspective, secured lines of credit are attractive because they provide a way to recoup the advanced funds in the event of nonpayment.
For individuals or business owners, secured lines of credit are attractive because they typically come with a higher maximum credit limit and significantly lowerinterest ratesthan unsecured lines of credit. Unsecured lines of credit are also more difficult to obtain and often require a higher credit score or credit rating. Lenders attempt to compensate for the increased risk by limiting the number of funds that can be borrowed and by charging higher interest rates. That is one reason theannual percentage rate (APR)on credit cards is so high.
Credit cardsare technically unsecured lines of credit, with the credit limit—how much you can charge on the card—representing its parameters. But you do not pledge any assets when you open the card account. If you start missing payments, there"s nothing the credit cardissuercan seize in compensation.
A line of credit can have a major impact on your credit score. In general, if you use more than 30% of the borrowing limit, your credit score will drop.
Revolving vs. Non-Revolving Lines of Credit
A line of credit is often considered to be a type of revolving account, also known as an open-end credit account. This arrangement allows borrowers to spend the money, repay it, and spend it again in a virtually never-ending, revolving cycle. Revolving accounts such as lines of credit and credit cards are different from installment loans such as mortgages and car loans.
With installment loans, consumers borrow a set amount of money and repay it in equal monthly installments until the loan is paid off. Once an installment loan has been paid off, consumers cannot spend the funds again unless they apply for a new loan.
Non-revolving lines of credit have the same features as revolving credit (or a revolving line of credit). A credit limit is established, funds can be used for a variety of purposes, interest is charged normally, and payments may be made at any time. There is one major exception: The pool ofavailable creditdoes not replenish after payments are made. Once you pay off the line of credit in full, the account is closed and cannot be used again.
As an example, personal lines of credit are sometimes offered by banks in the form of an overdraft protection plan. A banking customer can sign up to have an overdraft plan linked to his or her checking account. If the customer goes over the amount available in checking, the overdraft keeps them from bouncing a check or having a purchase denied. Like any line of credit, an overdraft must be paid back, with interest.
Types of Lines of Credit
LOCs come in a variety of forms, with each falling into either the secured or unsecured category. Beyond that, each type of LOC has its own characteristics.
Personal line of credit
This provides access to unsecured funds that can be borrowed, repaid, and borrowed again. Opening a personal line of credit requires a credit history of no defaults, a credit score of 670 or higher, and reliable income. Having savings helps, as does collateral in the form of stocks or CDs, though collateral is not required for a personal LOC. Personal LOCs are used for emergencies, weddings and other events, overdraft protection, travel and entertainment, and to help smooth out bumps for those with irregular income.
Home equity line of credit (HELOC)
HELOCs are the most common type of secured LOC. A HELOC is secured by the market value of the home minus the amount owed, which becomes the basis for determining the size of the line of credit. Typically, the credit limit is equal to 75% or 80% of the market value of the home, minus the balance owed on the mortgage.
HELOCs often come with a draw period (usually 10 years) during which the borrower can access available funds, repay them, and borrow again. After the draw period, the balance is due, or a loan is extended to pay off the balance over time. HELOCs typically have closing costs, including the cost of an appraisal on the property used as collateral.
Since the Tax Cuts and Jobs Act of 2017, interest paid on a HELOC is only deductible if the funds are used to buy, build or substantially improve theproperty that serves as collateral for the HELOC.
Demand line of credit
This type can be either secured or unsecured but is rarely used. With a demand LOC, the lender can call the amount borrowed due at any time. Payback (until the loan is called) can be interest-only or interest plus principal, depending on the terms of the LOC. The borrower can spend up to the credit limit at any time.
Securities-backed line of credit (SBLOC)
This is a special secured-demand LOC, in which collateral is provided by the borrower’s securities. Typically, an SBLOC lets the investor borrow anywhere from 50% to 95% of the value of assets in their account. SBLOCs are non-purpose loans, meaning the borrower may not use the money to buy or trade securities. Almost any other type of expenditure is allowed.
SBLOCs require the borrower to make monthly, interest-only payments until the loan is repaid in full or the brokerage or bank demands payment, which can happen if the value of the investor’s portfolio falls below the level of the line of credit.
Business line of credit
Businesses use these to borrow on an as-needed basis instead of taking out a fixed loan. The financial institution extending the LOC evaluates the market value, profitability, and risk taken on by the business and extends a line of credit based on that evaluation. The LOC may be unsecured or secured, depending on the size of the line of credit requested and the evaluation results. As with almost all LOCs, the interest rate is variable.
Limitations of Lines of Credit
The main advantage of a line of credit is the ability to borrow only the amount needed and avoid paying interest on a large loan. That said, borrowers need to be aware of potential problems when taking out a line of credit.
Unsecured LOCs have higher interest rates and credit requirements than those secured by collateral.Interest rates (APRs) for lines of credit are almost always variable and vary widely from one lender to another.Lines of credit do not provide the same regulatory protection as credit cards. Penalties for late-payments and going over the LOC limit can be severe.An open line of credit can invite overspending, leading to an inability to make payments.
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