Whether you need money to pay your bills, start a business, or anything else, taking a line of credit probably isn’t the first option that comes to mind.
However, this less marketed method of borrowing money might be the option that suits you best.
Why do you need credit?
Most people who need money opt for a bank loan, or look for a friend or relative willing to lend them money. But, a line of credit (also referred to as an evergreen loan) is a short-term funding option that might be worth considering.
Businesses often use credit lines for payroll and to cover the gaps when the monthly income is irregular, but credit lines aren’t so widely used by individuals yet.
What is a line of credit?
A line of credit is an account that lets you borrow money as and when you need it, up to a maximum limit, without applying for a loan multiple times. A bank or any other lender may give you this type of short-term funding at a fixed or variable interest rate.
Before approving you for a line of credit, lenders also consider other factors, such as your debt-to-income ratio, your business’s profit margin, and your credit score. Additionally, they check your ability to repay the loan, your assets, and the amount of debt you currently have.
Some lenders also ask for references from other banks or businesses that are willing to vouch for your creditworthiness.
How does a line of credit work?
Once you are approved for a line of credit, you can write cheques or use that bank’s card to make purchases with your pre-defined credit. The money you use has to be paid back within a specific period defined by the lender and may be charged a variable rate of interest.
This is a flexible lending option because the borrower can access money from the credit line at any time, as long as they don’t exceed the maximum borrowing limit on that line. So, you can borrow money, pay it back, and then borrow money again without applying for credit a second time.
An approved credit line is valid for a defined period, usually a few years. After the period is over, you can continue repaying your outstanding debt, but you can’t make purchases using that credit line anymore.
Secured vs. unsecured line of credit (LOC)
A line of credit can be either secured or unsecured. Read on to learn about the differences between secured and unsecured lines of credit.
Essentially, a secured line of credit allows the lender to hold some portion of your assets as a security against your line of credit. If you don’t meet obligations associated with your credit line, for example, if you fail to repay the debt for a long period, the lender can use a portion of your assets to repay the outstanding money.
Secured lines of credit come with a higher maximum credit limit and a significantly lower interest rate because they are less risky for the lender. In addition, a secured line of credit may have a better chance of being approved than an unsecured one. An example of a secured credit line is a credit line backed by your home.
Unsecured credit lines are generally harder to obtain and require the borrower to have a good credit score. This type of loan is riskier because there is no collateral to back up the money lent to you. This type of credit line is generally used for smaller expenses. For example, your credit card is an unsecured line of credit.
While both these credit lines have a variable interest rate, here are their key differences.
A secured line of credit
- The loan is backed by collateral
- Has a lower interest rate
- Has a higher credit limit
- Easier to get approved for
Unsecured line of credit
- No collateral is needed
- Has a significantly higher interest rate
- Has a lower credit limit
- Harder to get approved for
Revolving vs. non-revolving LOCS
A line of credit is known to be a type of revolving account because you can access your available credit as you need it. You can borrow money, pay it back, and then borrow again and continue the cycle for as long as your credit line is valid without applying separately each time you borrow.
For example, you might use a revolving line of credit to pay for a new car or make a large purchase. When you use the credit, you must pay back the loan with interest, just like any other loan.
The main difference between a revolving line of credit and a typical loan is that a revolving line of credit can be used again without a new application. So, once you pay back the debt for the car, you can easily use this line of credit to purchase a new TV.
Non-revolving credit has similar features to a revolving line of credit, like a credit limit, a due date to repay the loan, and interest rates. The key difference here is that you will likely have to apply for a new loan to borrow money again once you pay back the borrowed amount.
Types of credit lines
Credit lines can be classified into many different types, each having unique characteristics.
However, each type can be classified as either a secured or an unsecured type of credit. The five main types of credit lines you may want to know about are:
Personal line of credit
A personal line of credit is a personal loan given to you to spend as you please, like for a wedding or for travel. It offers you the flexibility to use the money as you see fit, and it’s often a smart option if you need a quick infusion of cash. A personal line of credit is unsecured, so it would require you to have a credit score of 670 or above for approval.
Home-equity line of credit (HELOC)
Home equity lines of credit are secured loans that enable you to borrow against the value of your home. You can use this credit to finance purchases like a new car or pay off some of your other debts.
Demand credit lines
A demand loan can be secured or unsecured. It is a short-term loan, and the term length varies depending upon the lender. With a demand line of credit, the lender can demand re-payment of the borrowed amount at any time, which could be in the form of interest-only payments or payment of the interest plus the principal amount in full.
Securities-backed credit lines are where the borrower’s securities serve as the collateral assets for the credit line. Typically, a person can borrow anywhere between 50% and 95% of the value of the securities in their account.
Because this type of credit is backed by securities, the borrower cannot use the loan to buy or trade securities, but they can use the money for any other type of expenditure.
Business lines of credit
A business line of credit is a financial tool that helps business owners in times of growth or expansion. This line of credit can be secured or unsecured based on the size of the line requested and the profitability of the business.
This credit can be used by the business as and when they need it, which is more convenient than taking out a fixed loan. For instance, a company may need short-term working capital to tide over a cash crunch, fund an upcoming project, or meet a sudden cash requirement for a specific purchase.
When is a line of credit useful?
There are many reasons to opt for a credit line over alternative money lending options.
- A line of credit can help you get the financing you need without going through a lot of red tapes, so it may be a smart way to handle emergency expenses. They are not meant for one-time purchases, but for smaller expenses and repeated cash outlays that banks usually wouldn’t loan money for, like covering the gaps while having an irregular monthly income.
- A line of credit can be a valuable tool to help you build up your credit score. If you use your line of credit responsibly, it makes it easier for you to get loans in the future.
- If you want the flexibility to use credit whenever and however you need it, and re-pay on your terms, a line of credit might be worth considering. However, it is still smart to pay off your due balances regularly to avoid paying large amounts in interest.
Problems with credit lines
A line of credit can be helpful in a few situations, but it’s typically not wise to rely on credit lines for every financial need. It’s essential to understand the limitations and drawbacks of credit lines before applying for one.
- Short-term solution: A line of credit is often only a short-term solution for quick funds, and it’s smart to be regular with paying back the borrowed money to avoid your debt from multiplying. It can not be used as a long-term loan. If you aren’t careful, the high-interest rates on this type of credit can lead to a large outstanding amount very quickly.
- Limited amount: Credit lines usually have a maximum limit, which is the maximum amount that the lender will finance for you. This can be limiting if you needed a larger amount of money.
- High-interest rates: Another drawback is that the interest rate for such credit is very high, and varies from lender to lender. Unsecured credit lines have a higher interest rate than secured credit lines that are backed by collateral.
- Complicated interest calculations: Interest is charged as soon as you draw money from your credit line, and there’s no fixed schedule for repaying the dues. This makes the interest calculations a little confusing, and borrowers might be surprised at what they end up paying in interest because of this.
- Easy to overspend: An open credit line makes it very easy for you to overspend and land up in a large pile of debt that you’re unable to pay.
- Lower credit score: If you misuse your credit line and default regularly, it can lower your credit score. This reduces your creditworthiness and you’re charged a higher rate of interest for any loans you take in the future.
- Maintenance fee: Some banks charge you a maintenance fee if you don’t use your available line of credit. Credit lines can be very convenient for some businesses and people, but they aren’t necessarily wise for everyone.
Let us compare how credit lines are different from credit cards.
Credit line vs. credit card
Credit lines and credit cards are often confused because both are common examples of revolving credit. With both options, you have a maximum limit you can borrow up to, but you don’t have to borrow anything immediately after being approved for the credit. You’re free to use the credit as and when you need it, and you’re only charged interest on the amount you utilize from the available credit.
However, here are some key differences between the two:
- APR: APR on a line of credit is generally lower than the APR for credit cards.
- Rewards: Many credit cards offer rewards for spending. For example, Vital offers you cashback rewards for your spending. Credit lines do not offer these rewards.
- Grace period: Credit cards offer you a grace period to pay your outstanding debt before charging you interest. Credit lines, on the other hand, charge you interest as soon as you spend using the available credit.
Lines of credit, like any other form of borrowing, can have some benefits. How beneficial they can be for you depends on how efficiently you’re able to use them, and whether they satisfy your credit needs. But, with this understanding of what a credit line is, you’re now equipped to decide if credit lines are the right fit for you.
If you are exploring various ways of securing credit, consider signing up with us. We offer users 1.5% cash back on all purchases and can help you increase your credit score. We are the credit card that pays you to share and spend responsibly.
What is a good credit score | Equifax
How to Improve Your Credit Score | Experian
Vital Card blog posts are intended for informational purposes only and should not be considered financial or any other type of advice.