What Is a Credit Line?
A credit line, also known as a line of credit, is a set amount of debt that individuals, businesses, governments, or other organizations may incur from another entity.
An example of a line of credit is if a business lets another business purchase supplies on credit, with the agreement that payments can be made at agreed-upon intervals, in full or partial, with or without interest. This type is generally an unofficial line of credit, where an official line of credit from a bank requires an application and approval.
The Advantages of Having a Line of Credit
Once approved, you generally may borrow whenever you need to, up to an agreed-upon limit. This is very convenient for businesses, as it allows them to purchase items they need at the times they need them.
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.
A draw period is the span of time in which you may borrow money from a line of credit, which may last up to 20 years. The repayment period, where you must pay back any amounts you borrowed during the draw period, commences directly after the draw period ends.
Examples of Credit Lines
Credit cards are one example of a line of credit. You are given a limit you can charge on an account, and you start with a zero balance due. You then use the card to make purchases as needed.
Each month, you may pay off the loan in full or in portions (for an extra charge, called interest) and start borrowing again within the same month. Lingering balances typically carry hefty interest penalties and compound the amount due very quickly.
Home equity lines of credit (HELOCs) let homeowners obtain cash using the equity in their homes. Lenders typically limit the amount you can borrow to 80% of your home’s value.
Business lines of credit provide working capital to small businesses. Because the fiscal needs of a business are usually fluid, it's not practical to constantly apply for new traditional loans, so credit lines make flexible borrowing simple and convenient.
Compare and Contrast
Credit lines differ from standard auto and home loans where you borrow lump sums of money upfront after approval. But if you subsequently realize that you require additional funds, you must apply for an entirely new loan.
This can be inconvenient and may take time. Contrarily, with credit lines, borrowers don't have to reapply for new loans every time they need money. If you expect to borrow money multiple times throughout the year, a credit line might be the easiest option.
This type of loan helps borrowers manage cash when expenses are unpredictable, and they can even be attached to checking accounts to prevent overdraft charges.
Managing the Credit Line
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. If you are charged interest on your credit line, it can add up fast if balances are not paid off.
Credit lines are best used as safety nets when one suddenly needs immediate cash to cover an unexpected expense. Credit lines may not be ideal for routine business long-term borrowing, due to the high-interest rates, but can work wonders for short-term borrowing.
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 your credit scores
- Your available income to repay the loan
- Assets you can pledge as collateral
Collateral is an asset used to secure the loan that your lender may seize and sell if you fail to repay the loan according to the agreed-upon terms. Borrowers often put up their homes as collateral, for large home equity lines of credit, with low-interest rates. But a borrower runs the risk of losing their home to foreclosure if payments are missed.
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.
Money parked in savings accounts and certificates of deposit (CDs) may also be used as collateral to secure loans if you are borrowing from the same bank that holds your savings. This advantageous approach lets you continue earning interest in those accounts while eliminating the risk of losing the asset you used as collateral.
It’s possible to get unsecured lines of credit where borrowers are granted loans without posting collateral. But approval is more difficult and interest rates generally are higher because the bank is taking a greater risk.
Surprises From Your Lender
Unfortunately, banks can reserve the right to cancel your line of credit or lower your borrowing limit at any time. They may also raise the interest rates at will. For both of these reasons, it's important to keep emergency cash reserves available and keep your credit lines for important purchases only.