A line of credit is a predetermined amount of money that a lender, usually a bank, has agreed to loan you. Every line of credit has both a “draw period” and interest rates. A draw period refers to a specific length of time during which you can access money from that account. Once this period ends, you start repaying the loan.
One major perk of taking out a line of credit is that you choose when to withdraw the money. Additionally, loan installments only start when you use that money. So, if it goes untouched for a while, you won’t have to worry about it.
Loan installments happen in a cyclical pattern. You borrow, repay, repeat.
Having a good credit score is another factor that can influence whether a potential lender will approve you for a line of credit and, if so, for how much.
Read on as we explore how a line of credit works and the various types of credit in further detail.
Types of lines of credit
Lines of credit come in multiple forms. The five most common types are as follows:
Personal line of credit
Personal loans apply to various life situations, including emergencies, weddings, travel, or home projects. Essentially, they act as a cushion alongside one’s regular income.
Personal lines of credit are essentially unsecured loans, meaning that a collateral fee isn’t required before the lender approves the borrower. The conditions to obtain this loan include good credit history, a credit score of 670 or higher, and a steady income.
Home equity line of credit
A home equity line of credit is the most common type of credit. The loan amount is determined by the market value of a house subtracted from the mortgage balance. Typically, a home equity line of credit is 75–80 percent of that value.
The draw period for this type of credit is usually a maximum of 10 years.
Demand line of credit
Demand lines of credit can either be unsecured or unsecured. The latter refers to the borrower having to pay collateral. As its name indicates, the lender can demand that the borrower repay the loan at any time. In terms of fees, the borrower pays interest only, interest plus principal, or a one-time upfront fee.
Securities-backed line of credit
This type of credit allows the borrower to invest 50–95 percent of their personal assets into the credit account as collateral, such as jewelry, stocks, or their home. It is important to remember that you will lose that property if you cannot pay back the line of credit.
These loans are not valid for buying or trading securities.
Business line of credit
A lender approves a business for loans when it is deemed professionally necessary. This credit can either be secured or unsecured. Approved limits are often lower than regular loans, and interest rates can vary.
Why do people use a line of credit?
One: Overdraft protection. This applies to individuals who write checks frequently but have an unstable income. A line of credit can function like a financial safety net.
Two: Business opportunities. A business can use a line of credit as collateral payment to expand, promote its products, or participate in trading.
Three: Irregular incomes. If your paychecks are erratic, having a line of credit is a reliable way to ensure that you can pay your monthly bills.
Four: Funding private projects, such as home repairs or weddings.
Five: Emergencies. A line of credit can help reduce stress if an unforeseen medical situation arises. For instance, you can use this money to settle your taxes or pay your debts, while your traditional income can go toward health care costs.
Disadvantages of using a line of credit
Like many financial endeavors, there is an evaluation process you must go through. Consequently, those with a fair or poor credit score will have a more challenging time getting approved. Second, interest rates are vulnerable to change and vary widely from lender to lender. Since a line of credit is “money on demand,” this can lead to overspending, and misusing your credit can damage your credit score.
Finally, don’t just borrow money because you can. Regardless of its title, a line of credit is still a loan, and if you cannot repay it, you will go further into debt.
How to apply for a line of credit
Step 1: Decide what type of line of credit is best suited to your needs.
Step 2: Know your credit scores. Your credit history and credit score provide banks and other lenders an overall idea of how reliable you are as a consumer and borrower. The more favorable your financial background information is, the simpler and swifter it will be to obtain a line of credit.
Step 3: Request a reasonable amount. Lenders aren’t inclined to approve unnecessarily high loans. Be realistic. Remember, you can borrow more after you repay.
Step 4: Submit the completed credit application.
Lines of credit versus credit cards
A line of credit and a credit card are very similar. Each one is a revolving line of credit, meaning a cyclical pattern characterizes it. You borrow the money, repay the money, and then you can do it all over again.
Credit cards have no draw periods. If you act responsibly and can pay off your credit card bills at the end of every month, you can use it as long and frequently as you like. Credit cards also have higher interest rates, but many cards offer rewards programs like cash-back on purchases.
Lines of credit versus traditional loans
A loan is a fixed amount of money that you pay interest on immediately, even if you don’t use that money right away. Again, a line of credit is available when you need it, and its accompanying installments begin when you start drawing from the credit account.
There are fewer restrictions associated with a line of credit. You can use this credit for anything. Traditional loans must be for the purpose for which they were approved. So, if you take out a loan for a mortgage, you must use that money to make mortgage payments and nothing else.
In both cases, actively paying your subsequent installments on time can boost your credit score.
Lines of credit versus payday
Payday loans are unsecured cash advances. A typical amount for a payday loan is $500. Those who use lines of credit and payday loans are both able to borrow, pay it back, and start all over again. No lender cares what the money goes toward, as long as the borrower repays it in full.
The amount of a line of credit is significantly less than a payday loan. The latter is also approved much quicker, and credit checks typically happen during the evaluation process. However, payday loans also come with high interest fees and shorter repayment periods.
Revolving versus non-revolving lines of credit
Again, lines of credit are revolving credit accounts, also called open-end credit accounts, and borrowers take part in a cyclical sequence of behavior. The most common example of revolving credit is a credit card loan.
Non-revolving lines of credit are not renewable. Once a borrower repays a non-revolving line of credit in full, that account is officially closed. Examples of this type of credit include car loans, appliance loans, and most real-estate loans.
Revolving and non-revolving lines of credit both offer flexibility to borrowers and can fulfill multiple financial purposes.
Having access to a line of credit can be extremely helpful in many circumstances. Qualifying depends on your history, your personal decisions, and, in some cases, your level of wealth.
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