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A line of credit (LOC), sometimes called a bank line or personal line of credit, is an account you can open with a bank or credit union that lets you borrow money when you need it, up to a preset borrowing limit.
With a personal credit line, you only pay interest on the money you borrow, and as you pay back borrowed funds, your available credit is replenished. In other words, you can use a personal line of credit pretty much the same way you use a credit card.
Interest rates on lines of credit can be significantly lower than credit card rates, however, especially if you have good credit scores. And since you only pay if and when you use it, setting up a personal credit line be a good strategy for dealing with "rainy day" expenses you can't pay in full from your emergency savings or other sources of cash.
The Difference Between Personal Loans and Lines of Credit
When you borrow money from a bank, credit union or online lender, you have two broad options: personal loans and lines of credit. Here are some of the differences between the two:
- With a loan, you get the loan amount in a lump sum and must start making monthly payments (including interest charges) immediately, continuing for the duration of the loan, which may be anywhere from 24 to 60 months. With a line of credit, you have access to a maximum amount of money—your credit line or borrowing limit—but you don't pay interest or make payments until you use your credit.
- A loan requires you to pay the same amount, or installment, every month for the life of the loan. With a credit line, you can pay back what you owe in payments of any amount above a specified monthly minimum, so if you're able, you can pay back what's owed in a few large payments (and pay relatively little interest) or spread smaller payments over a longer period of time (at a greater cost in interest charges).
Personal Line of Credit vs. Credit Cards
While there are many similarities between personal lines of credit and credit card accounts, there are distinct differences as well:
- LOCs are typically less costly to use than credit cards. Some personal lines of credit currently have interest rates of 13% or so for borrowers with good credit scores (though lower rates may be available to individuals with exceptional credit). That compares to an average credit card interest rate of about 16% these days.
- It's much easier (and less costly) to get cash from a personal LOC than from a credit card. With a personal credit line, you are typically issued a checkbook and a debit card that you can use make purchases or payments, or convert to cash easily (by cashing checks or making ATM withdrawals with the card). Taking out a cash advance from a credit card can be much more expensive. The average interest rate on credit card cash advances is more than 23%, and many card issuers also charge additional fees of 5% or so on the amount of each cash advance.
- Personal LOCs have shorter lifespans than credit card accounts. You can maintain a credit card account indefinitely, as long as you choose to keep it open and continue to make payments as agreed. By contrast, a personal LOC is typically open for just a few years, and its life cycle consists of two distinct phases:
- A draw period, during which the account revolves, allowing you to borrow and repay money freely.
- A repayment period, during which you may no longer borrow against the credit line, but must repay all outstanding balances.
The duration of the draw and repayment periods are set when you open the LOC; three to five years is common for each.
Secured and Unsecured Lines of Credit
When you take out a secured loan, you agree to let the lender use one of your personal assets as collateral, to ensure they can recover some or all of their loss if you fail to repay the loan. If you fail to make payments, the lender can seize the asset and sell it to recoup what you owe. A car loan is an example of a secured loan, in which the car itself serves as collateral.
Like most credit cards, most personal credit lines have no collateral backing them, and so they are considered unsecured credit. There are, however, two categories of secured personal lines of credit:
- A CD-secured line of credit uses money you have on deposit in a certificate of deposit (CD) as collateral. Because the line is secured, its interest rate is typically lower than those on unsecured LOCs. You may be able keep a secured line of credit open for more than the three- to five-year spans that are common with unsecured personal lines of credit.
- A Home Equity Line of Credit (HELOC) is a secured line of credit that uses your house as collateral. More specifically, as its name implies, a HELOC uses the equity in your home as collateral—that is, the amount by which the appraised value of the home exceeds the unpaid principal balance on its mortgage. If, for example, you have paid off $100,000 in mortgage principal on a $400,000 mortgage, your unpaid principal equals $300,000; if your home is appraised for $500,000, your equity would be that appraised value, ($500,000) less the unpaid principal ($300,000), or $200,000.
HELOCs typically have draw periods of five to 10 years, followed by repayment periods of 10 to 20 years.
Historically, part of what made HELOCs attractive was the ability claim up to $100,000 in HELOC interest payments as a federal income tax deduction, no matter how much interest was claimed as a deduction on a primary home mortgage. The tax reform law that took effect in 2018 curtailed that quite a bit; it only allows the deduction of HELOC interest paid on funds borrowed for home improvement projects, and it limits homeowners to a maximum deduction of $750,000 in combined interest payments on their primary mortgages and HELOCs.
How a Personal Line of Credit Can Impact Credit Scores
Like a credit card account, a personal line of credit is a form of revolving credit in which a lender authorizes you to borrow against an approved credit limit and make repayments in variable amounts over time. Also like a credit card account, your management (or mismanagement) of a personal credit line can have a major impact on your credit scores.
Both the FICO® Score* and VantageScore® credit scoring systems give significant weight to your handling of revolving credit. More specifically, they are sensitive to credit utilization—the percentage of your borrowing limit that you owe at any given time. Most credit scoring experts recommend keeping utilization below 30%—on each revolving account individually and on all of them combined—to avoid lowering your credit score. For more information on credit utilization, including detailed instructions on how to calculate it, see "What Is a Credit Utilization Rate?"
If you use more than about 30% of the borrowing limit on a personal LOC, you can expect your credit scores to go down and to stay somewhat depressed until you repay enough of the balance to get utilization back below 30%.
Applying for a Personal Line of Credit
If you choose to apply for a personal line of credit at a bank, credit union or online lender, here are some considerations to keep in mind.
- Credit scores count. Your credit scores will be a major factor in determining whether you qualify for a line of credit, and the interest rate you are offered. Check your scores ahead of applying for a line of credit. Taking steps to boost your credit scores may help you qualify for a better line of credit deal.
- Line limits vary. Some lenders limit lines of credit to $15,000 to $30,000, while others offer qualified clients with savings accounts at the bank credit lines that stretch to six figures.
- Interest rates can change. Unsecured lines of credit typically come with variable interest rates, which can and probably will change over time. Variable rates are tied to a specific financial benchmark index or interest rate. As that rate changes, so will the interest rate you owe on your line of credit.
- Fees apply. The fees associated with personal lines of credit are pretty minor, but you should be aware of them: There are typically no origination fees for opening a personal LOC, but some lenders might charge annual fees of $25 to $50.
Versatile and Valuable
As a flexible, cost-effective alternative to credit cards, a personal line of credit can be useful in financial emergencies, or to help smooth out periods when household income or expenses are inconsistent. As long as you understand its advantages and limitations, and are mindful of its potential impact on your credit, a personal LOC could be a useful addition to your credit toolbox.
Editorial Disclaimer: Opinions expressed here are author's alone, not those of any bank, credit card issuer or other company, and have not been reviewed, approved or otherwise endorsed by any of these entities. All information, including rates and fees, are accurate as of the date of publication.
This article was originally published on October 3, 2017, and has been updated.
*Credit score calculated based on FICO® Score 8 model. Your lender or insurer may use a different FICO® Score than FICO® Score 8, or another type of credit score altogether. Learn more.