What Is a Credit Line?

Illustration of a faucet pouring our money
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A credit line, also known as a line of credit (LOC), is a helpful tool that individuals, businesses, or other organizations can use to access cash when they need it. They can come in various forms, from a credit card to a home equity line of credit (HELOC) to a small business credit line.

These loans often make it possible to complete projects or do business when you don't have the necessary cash on hand. But they can also be risky, as any time you take on debt and delay paying it back, you're assuming you'll be able to meet your obligation later.

How Does a Credit Line Work?

A line of credit is different from a traditional loan. With the latter, you apply for a sum of money and pay it back in installments within that set time frame. You can't continually take out new money against the same loan.

With a credit line, however, you are applying for regular access to cash when you need it. It's usually understood that you may take out money repeatedly throughout the life of your loan. They can come in several forms, all of which serve different purposes.

  • Credit cards for open-ended, revolving consumer spending
  • HELOCs that use your home equity as leverage to pay for costs of repairs, improvements, or even other spending
  • Business credit lines that you can use to cover major expenses or operating costs

The best line of credit for you will depend on factors such as your personal or business credit rating, what you have available (and want to) put forth as collateral, and the reason for your loan.

Credit Card vs. Line of Credit

A credit card is the most common type of credit line. You receive a credit card with a set balance limit and you can continually spend up to the limit as long as you're meeting your payment terms each month.

With a more traditional line of credit, you might actually have a defined draw period, during which you can repeatedly draw money up to the limit and make interest-only or interest-plus-principal payments. Once you enter the repayment period, however, your balance is due according to the repayment schedule you agreed to with your lender.

Secured Credit vs. Unsecured Credit

Like other loans, credit lines can be secured or unsecured. With a secured loan, your lender requires you to use a personal asset (or assets) as collateral that the bank can seize if you default. A home equity line of credit is a common type of secured credit line. Your HELOC lender will have a claim to that portion of your home's equity if you default on your loan.

A credit card, on the other hand, is an example of an unsecured credit line. Instead of requiring an asset as collateral, your card issuer grants you access to funds based on your financial situation and credit history. If you become delinquent on payments, the credit card company can send your account to collections, but it can't go after any of your tangible property without taking you to court. 

Because secured loans represent a lower risk for your lender, they usually have a lower interest rate than unsecured loans.

Revolving vs. Non-Revolving Lines of Credit

Most lines of credit are revolving, or open-end accounts that allow you to continually draw money up to the limit as long as you are making payments according to your account terms. Some are non-revolving, or closed-end accounts, however. In that case, once you have paid back the balance, you cannot continue drawing funds. A HELOC may work this way once you enter the repayment period, after which you can no longer draw new funds.

Managing the Credit Line

Before you take out a line of credit for yourself or your business, do everything you can to secure the best rate and terms. That means making sure your credit rating is as strong as possible, you don't have too many other obligations, and if you're a business, that you're on good terms with vendors.

Once you have a credit line, don't treat it like a cash lifeline you can tap whenever you want. You might receive a checkbook or a payment card that draws from your pool of available funds to help you manage your credit line. It is important to manage your interest payments by paying off your balances on time.

Benefits and Drawbacks of Credit Lines

Benefits
  • Immediate access to cash

  • Only have to borrow what you need

  • Interest-only payments during a draw period (if applicable)

  • Can usually keep borrowing as needed

Drawbacks
  • Higher interest rates than traditional loans

  • Interest adds up when not paying principal

  • Secured LOC puts assets at risk

  • Can cause problems if relied on too much

  • Bank could decide to cancel your LOC, lower your limit, or change your rate any time

Benefits Explained

A line of credit is a great way to gain quick access to cash. This is especially convenient for businesses, but a personal credit line can be helpful for something simple such as checking account overdraft protection.

Although credit lines generally have maximum borrowing limits, you need not borrow the entire amount allowed. Rather, you may borrow a small amount today and more at a later time on an as-needed basis.

If you have a loan with a draw period, you can finance major projects without having to worry that you need to start paying everything back next month. This can be a great option for financing a home remodel right before you put it on the market, for example.

Drawbacks Explained

On the other hand, the interest on a line of credit is often higher than a traditional loan, and that can add up quickly if you're not paying down the principal. Banks might reserve the right to cancel your line of credit, raise rates, or lower your borrowing limit at any time, so it's important to keep emergency cash reserves available and use credit lines for important purchases only. If you rely on your credit card or any other line of credit too much, you can get into serious debt, ruin your credit, and even face collectors.

If you have a secured line of credit, a lender may seize your home or other collateral, so think twice before you offer any of your assets to secure a credit line. For business owners, it may be more prudent to put up business assets as collateral such as commercial property, work vehicles, or equipment to keep them from losing personal assets.

How to Get a Line of Credit

To obtain a line of credit, you must apply as you would with any other loan. Lenders will decide whether to approve your application and will determine your borrowing limits based on the following lending criteria:

  • Your borrowing history and credit scores
  • Your available income to repay the loan
  • Assets you can pledge as collateral

The Bottom Line

A line of credit can be a powerful tool in your financial toolbox. But, as with any other loan, you should use it with care. A loan is never a free pass to avoid financial responsibility. Make sure you can afford to repay your debts before you enter into them.

Article Sources

  1. Consumer Financial Protection Bureau. "Differentiating Between Secured and Unsecured Loans." Accessed May 11, 2020.

  2. Nolo. "What Can Creditors Do If You Don't Pay?" Accessed May 11, 2020.

  3. Federal Trade Commission. "Home Equity Loans and Credit Lines." Accessed May 11, 2020.