How a Line of Credit Works

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A line of credit is a pool of available money that you can borrow from. When you are approved for a line of credit, you get the ability to spend money, but you don't actually borrow or pay interest until you access the funds.

Home Equity Lines of Credit

The most common line of credit for consumers is a home equity line of credit (HELOC). With this type of loan, your home equity (that is, the value of your home that you truly own) serves as collateral. 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).

Why is the interest rate lower? 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. Your credit limit will be determined, in part, by your loan to value ratio, your credit scores, and your income.

Home Equity Loan

Sometimes it's helpful to compare and contrast different types of loans. A HELOC is similar to a home equity loan, but there are some important differences.

Generally, a HELOC is more flexible than a home equity loan. You only borrow what you need, and you can typically go back for more money when you need to, as long as you stay below your maximum credit limit and as long as your lender does not cancel your line of credit unexpectedly. You might use a checkbook or payment card to access your line of credit.

With a home equity loan or "second mortgage," you do it all in one shot. You'll get the entire maximum loan amount in one lump sum, and you'll have to pay interest on the entire loan balance. With a HELOC, on the other hand, you only owe interest on any outstanding loan balance.

Typically your monthly payments will remain the same each month with a home equity loans, and you'll have a fixed interest rate (or one that only changes periodically). A HELOC will have a variable rate that can change frequently, so monthly payments can vary.

Credit Card Lines of Credit

Again, a line of credit can be very similar to a credit card. Your credit card is a line of credit; you get to borrow up to a maximum limit, and you can repay and re-borrow numerous times.

Draw and Repayment Periods

Your line of credit will have a draw period and a repayment period. During the draw period, you borrow money and use your line of credit. It may last for 10 years or so, and it looks and feels similar to a credit card account. During the repayment period, you repay principal and interest on the loan.

Closing Costs

Like most loans, lines of credit have closing costs. Factor these in when you make your decisions on lenders and loan types.

Overdraft Line of Credit

Another type of line of credit is the overdraft line of credit, available in your checking account. That line of credit creates a small loan when you spend more than you have available in checking and is usually less expensive than an overdraft fee (assuming you only overdraw by a few bucks).