How a Line of Credit Works
A line of credit is a pool of available money that you can borrow from as you need it, something like a credit card. You have the ability to spend the money after you've been approved, but you don't actually have to borrow it or pay interest until you do access the funds.
How Do Lines of Credit Work?
Your line of credit will have a "draw period" and a "repayment period." You borrow from the pool of money during the draw period. This might be for 10 years or so. You'll repay the principal and interest on the loan during the repayment period.
When Do You Start Paying On a Line of Credit?
You'll also make minimum payments during the draw period. A portion of those payments will go to interest, but—like a credit card—the portion of your payments that represents principal can be added back to your credit line for future borrowing. This isn't the case with all lines of credit, however. Your payments during the draw period will represent only interest with some lenders.
The major difference between the draw period and your repayment period is that you'll have a set period of time within which to pay off your entire loan when you enter the repayment period.
Secured Lines vs. Unsecured Lines
Lines of credit are typically unsecured, but some do require that you 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 in the event that 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
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—Home Equity Lines
The most common line of credit for consumers is a home equity line of credit (HELOC). This is a secured type of 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 have to, assuming you stay below your maximum credit limit. You might use a checkbook or payment card to access the money.
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. You'll only pay interest on any outstanding loan balance you've borrowed with a HELOC.
Your monthly payments will typically remain the same each month with a home equity loan, 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.
As with a HELOC, your home acts as collateral and the lender can foreclose if you default.
Credit Card Lines of Credit
Again, a line of credit can be very similar to a credit card. Your credit card is effectively a line of credit. You get to borrow up to a maximum limit, and you can repay and re-borrow numerous times.
The major difference is that you'll most likely pay an increased interest rate if you try to take cash on a credit card—a "cash advance"—rather than directly charge a purchase.
Overdraft Lines of Credit
Another line of credit is the overdraft line of credit, available for your checking account. That line of credit creates a small loan if you spend more than you have available in your account. It's 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.
When Are These Lines of Credit Appropriate?
Few consumers can state with absolute certainty that they'll be employed next month or otherwise enjoy the same exact level of income well into the future. But you should be as sure of this as possible before you commit to any type of loan.
It's rarely advisable to take out a line of credit for "wants" rather than "needs." Reserve the option for consolidating credit cards with high interest rates into one payment with less interest, or for funding education. You might use the funds to repair or improve your home.
But you might want to rethink this option if you're taking out the line of credit to help you meet monthly expenses, because it's just going to increase the monthly expenses that you're already having trouble with. And it's rarely appropriate to fund a dream vacation or other expensive non-essential purchase.
Tips for Successful Borrowing
- As with most types of lending, your credit score can be critical. Consider waiting a while, if possible, if your score isn't great now. Take steps to improve it so you get better terms when you ultimately enter into 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.