How a Line of Credit Works
Lines of Credit Are Different Than a Standard Loan
A line of credit is a pool of money that you can borrow from as you need. A credit card is a common example, but there are other types of lines of credit. You have a set amount of money that you've been approved to spend, but you don't have to borrow it (or pay interest on it) until you decide you need the funds.
How Do Lines of Credit Work?
Your line of credit will have a "draw period" and a "repayment period." The draw period is the time that you have access to the credit—you can borrow money. This stage might last for 10 years or so, depending on the details of your agreement with the lender.
You'll repay the principal and interest on the loan during the repayment period. However, you will also be expected to make minimum payments during the draw period. A portion of those payments will go toward reducing your interest costs. The portion of your payments that go toward the principal can be added back to your credit line for future borrowing, but this replenishing effect isn't the case with all lines of credit. With some lenders, your payments during the draw period will represent only interest. This is another factor that will depend on the specifics of your credit line agreement.
The major difference between the draw period and your repayment period is that, when you enter the repayment period, you'll be given a set period within which you're expected to pay off your entire debt.
As you look toward your repayment period, use our loan calculator to understand the long-term cost of your line of credit:
When Are These Lines of Credit Appropriate?
Few consumers can state with absolute certainty that they'll be employed next month or otherwise ensure the exact same amount of income. Still, you should be as sure of this as possible before you commit to any type of loan, including a line of credit.
Like any loan, it's rarely advisable to take out a line of credit for "wants" rather than "needs." That means it probably isn't a good idea to use a line of credit to fund a dream vacation or major shopping spree. Reserve this option for major purchases and financial emergencies such as higher education or situations in which you need to consolidate high-interest credit card debt into one payment with lower interest rates. It's also common to use lines of credit to repair or renovate a home.
If you're taking out the line of credit to help meet monthly expenses, your finances could quickly spiral into debt. Paying off this month's expenses with debt is just going to increase next month's expenses.
Tips for Successful Borrowing
- As with most types of lending, your credit score can be critical. If your score isn't great now, you might want to delay taking out a line of credit, if possible. Take steps to improve your score so you get better terms on a line of credit loan.
- Know exactly what you're getting into. Not all lines of credit are created equally, and not all assert the same terms. Shop for the best deal with your personal situation in mind. Compare your options.
Secured or Unsecured?
Lines of credit are typically "unsecured," but some are "secured," which means that the borrower is required to put up collateral. The lender will place a lien against some item of your property, typically your home or your vehicle, but you might also be able to pledge a bank account or a certificate of deposit.
The lien acts as security if you default. The lender can foreclose or repossess your collateral if you fail to perform under the terms of the loan.
Lines of Credit vs. Personal Loans
|Lines of Credit vs. Personal Loans|
|Lines of Credit||Personal Loans|
|May cost more||May cost less|
|Borrowed amount is flexible||Borrowed amount is set|
|Borrowed amount is disbursed gradually||Borrowed amount is disbursed in a single lump-sum|
A line of credit will typically cost you a bit more in the way of interest than a personal loan would, at least if it's unsecured. Taking out a personal loan involves borrowing a set amount of money in one lump sum. You can't go on paying the principal back then reusing it as you can with a credit card or a line of credit.
Types of Lines of Credit
There are four main types of lines of credit: home equity lines, home equity loans, credit cards, and overdrafts. Learn more about each below.
Home Equity Lines
One of the most common lines of credit for consumers is a home equity line of credit (HELOC). This is a secured loan. Your home's equity—the difference between its fair market value and your mortgage balance—serves as the collateral. Your HELOC forms a lien against your property, just like your first mortgage. Your credit limit is determined by your loan-to-value ratio, your credit scores, and your income.
These loans are popular because they allow you to borrow relatively large amounts at relatively low interest rates compared to credit cards or unsecured loans. Banks consider these loans to be quite safe because they assume you'll repay the line of credit to avoid losing your home in foreclosure.
Home Equity Loans
A HELOC is similar to a home equity loan, but there are some important differences, and the two should not be confused. A HELOC is generally more flexible than a home equity loan. You only borrow what you need when you need it, and you can typically go back for more money if you need to—assuming you stay below your maximum credit limit. You might use a checkbook or payment card to access the money. You'll only pay interest on any outstanding loan balance you've borrowed with a HELOC.
You get the money all in one shot with a home equity loan, sometimes referred to as a "second mortgage." You'll get the entire maximum loan amount in one lump sum, and you'll have to pay interest on the entire loan balance from the inception.
In other words, home equity loans are more like traditional loans rather than lines of credit. The only difference is that, after you've repaid your home equity loan, you will have replenished the equity in your home, and you can take out another home equity loan.
Your monthly payments will typically remain the same each month with a home equity loan. Like a mortgage, you can have a fixed interest rate or one that only changes periodically. A HELOC, on the other hand, will have a variable rate that can frequently change so that the monthly payments can vary.
As with a HELOC, your home acts as collateral, and the lender can foreclose if you default.
Credit Card Lines of Credit
Your credit card is effectively a line of credit. You get to borrow up to a maximum limit. As you repay what you borrowed, that maximum limit is replenished. You can repeat this cycle of borrowing and repaying numerous times.
A major difference with credit cards compared to other lines of credit is that you'll most likely pay an increased interest rate if you try to take cash. These "cash advances" typically come with different rates than when someone directly charges a purchase at the point of sale.
Overdraft Lines of Credit
Another line of credit is the overdraft line of credit. These lines of credit are typically available for your checking account. It's essentially a small loan that is only triggered if you spend more than you have available in your account. The amount of the loan is just enough to bring your account back in the black again. It's usually less expensive than an overdraft fee, assuming you only overdraw by a few bucks.