What Is a Credit Line?
A credit line, also known as a line of credit, is a pool of money that individuals, businesses, governments, and other organizations may borrow from. Credit lines offer the following unique advantages:
Convenience: Once approved, you generally may borrow whenever you need to.
Borrowing what you need: Although credit lines have a 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.
Draw periods and repayment periods: 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
There are several different types of credit lines.
Credit cards start you off with a zero balance. You then use the card to make purchases as needed. Each month, you may pay off the loan in full and start borrowing again within the same month. But take note: Lingering balances typically carry hefty interest penalties.
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 percent of your home’s value.
Business lines of credit provide working capital to small businesses. Because the fiscal needs of 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 sumps of money up front 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. So if you expect to borrow money multiple times throughout the year, a credit line might be the easiest option. These loans help borrowers manage cash when expenses are unpredictable, and they can even be attached to checking accounts to prevent overdraft charges.
How to spend: You typically receive a checkbook or a payment card that draws from your pool of available funds.
Manage interest costs: Because interest charges accumulate once you start borrowing, it's wise to pay off your debts quickly.
Use wisely: Credit lines are best used as safety nets when one suddenly needs immediate cash to cover an unexpected expense. But credit lines are not ideal for routine use or for long-term borrowing. You may be charged a fee every time you draw on your credit line, and interest rates are typically higher than those connected to standard mortgage or auto loans.
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 determine your borrowing limits based on the following lending criteria:
- Your borrowing history. For most consumers, credit scores are examined.
- 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 his or her 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.
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 your home.
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 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. And they may also spike the interest rates at will. For both of these reasons, it's important to keep emergency cash reserves available.