Generally, a line of credit (LOC) is a flexible loan that borrowers can use, pay back, and use again at their discretion. While lines of credit are similar to other forms of credit, they also come with several different options and have diverse rules and regulations unique to each type. Read ahead for the breakdown of loan types and the requirements for each.
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What Is a Line of Credit (LOC)?
A line of credit (LOC) is a loan from a financial institution or a bank that the borrower can use for anything they need. It’s a flexible loan, meaning you can increase or decrease the amount borrowed and repay it how you see fit. However, the financial institution decides the maximum loan amount before the borrower gains access. As soon as the borrower accesses the loan, it starts accruing interest. The interest rate is also a variable rate, which means it’s hard to determine how much the loan will cost to borrow.
Understanding Credit Lines
Generally, all lines of credit are set amounts of loaned money that can be borrowed as necessary and paid back at once or in installments. Lines of credit are attractive because they’re flexible and can be accessed and applied to whatever the borrower sees fit. The financial institution decides the interest rate, payment size, and other vital elements.
Unsecured vs. Secured LOCs
An unsecured line of credit is similar to a credit card, accounting for most lines of credit. The lender doesn’t have any collateral to seize for loan repayment if the borrower misses payments. These loans are administered based on the borrower’s credit score, making eligibility more challenging. These loans are also typically issued with lower credit limits.
A secured line of credit is a credit line administered with collateral to back it up. If a borrower stops making payments to repay their loan, the lender can seize the collateral to recoup their loss. This type of loan is attractive to business owners because the limits are higher, and the interest rates are lower than unsecured loans.
Revolving vs. Non-Revolving Lines of Credit
Lines of credit are typically considered revolving accounts or open-end credit accounts. With a revolving account, a borrower can borrow the money, repay it, then borrow it again as many times as necessary.
Non-revolving lines of credit carry a combination of features of revolving lines of credit and installment loans. Borrowers can access their line of credit and use it as they see fit. The lender will charge interest and set the payment amount like a revolving line of credit. Like an installment loan, however, the borrower can only borrow from the line of credit once. Once they pay it back, the loan closes. They’ll have to apply for another line of credit to have access again.
Types of Lines of Credit
While researching the different types of lines of credit, those shopping for an LOC will be exposed to many different options. Here are a few of the most common:
Home Equity Line of Credit (HELOC)
A home equity line of credit is the most common line of credit. The home market value of the home minus the leftover portion of the mortgage acts as collateral for the LOC.
These lines of credit often include a draw period. The draw period is when the borrower can borrow from the line of credit without paying the principal back. Usually, the period lasts for ten years. The borrower only has to pay interest on the money they borrow until the period lapses.
Personal Line of Credit
A personal line of credit is a revolving line of credit that can be borrowed, repaid, and then borrowed again. Eligibility criteria typically includes:
- A credit score that is 670 or higher
- No defaults
- Having a steady income source
While collateral isn’t required for a personal line of credit, the applicant can make themselves more attractive to the lender if they have savings, certificates of deposit, stocks, or other collateral. This LOC is best for those with irregular income or those who need access to emergency funds.
Demand Line of Credit
Demand lines of credit are one of the less common LOCs on the market. These lines of credit are similar to the other lines of credit with interest rate variations and credit score requirements. The main difference is that this type of LOC can come due whenever the lender sees fit. Until the loan is called due, the borrower repays either the interest only or the interest plus the principal.
Securities-Backed Line of Credit (SBLOC)
Securities-backed lines of credit are backed by collateral in the form of a borrower’s securities. These types of loans provide an investor with a non-purpose loan, which cannot be used to trade or buy securities. A securities-backed line of credit will enable investors to borrow up to 95% of their accounts’ assets. Once the borrower utilizes the loan, they’re only required to make interest-only payments until it is either called due or repaid in full.
Comparing Lines of Credit to Other Types of Borrowing
When discussing borrowing for routine purchases or emergencies, financial institutions typically offer borrowers funds via credit card, general loan, or a payday/pawn loan. Different lines of credit have several things in common with each other. Each type also has several significant differences.
Credit Cards
Lines of credit and credit cards are similar in that both tools have a preset borrowing limit. Borrowers can also pay back the money they borrowed and then borrow from the same funds as often as they need. A significant difference between the two is that lenders can secure lines of credit with tangible items like real estate, while credit cards are almost exclusively unsecured loans.
Loans
Like loans, lines of credit require a specific credit score to be eligible to receive one. Also, like loans, borrowers can pay the loan back in installments or a single lump sum. Interest rates for lines of credit vary according to the market, while loan interest rates are the same for the life of the loan. Lenders also carry fewer restrictions for lines of credit than they do for loans.
Payday and Pawn Loans
Payday and pawn loans carry some of the same flexibility as a line of credit: the lender doesn’t care how the borrower uses the funds. The lender is also happy to let the borrower repeatedly borrow, extend, and repay a loan at high-interest rates and with many additional fees. Lines of credit have lower interest rates, making the cost of funds significantly lower than payday or pawn loans.
The Problems with Lines of Credit
While lines of credit are less expensive than a loan from a payday lender or a pawn shop, they still have their drawbacks:
- Some banks will charge maintenance or other monthly or annual fees to access the line of credit.
- The interest rates can be more complicated to calculate because they can be changed, drawn, or repaid at varying times.
- Unsecured loans are more expensive than a secured mortgage or car loan.
- Borrowers with poor credit may not qualify for the credit line.
How Does a LOC Affect My Credit Score?
Experian, Transunion, and Equifax track personal lines of credit the same way they track credit card accounts. They consider LOCs as revolving debt, which means payment history, maximum credit limit, and credit utilization count towards the overall credit score. Any debt on the credit line adds to your overall revolving debt. Like any credit, an LOC could help boost a borrower’s credit rating if used correctly.
However, it should be noted that lines of credit are becoming less common as time goes on. Some financial institutions have shut down lines of credit without warning, which could negatively impact a borrower’s score.