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A line of credit (LOC) is an account that lets you borrow money when you need it, up to a preset borrowing limit, by writing checks or using a bank card to make purchases or cash withdrawals. Available from many banks and credit unions, lines of credit are sometimes advertised as bank lines or personal lines of credit.
How Does a Line of Credit Work?
A personal credit line is a form of revolving credit that operates much like a credit card: You can write checks or make card payments in any amount up to your borrowing limit, and make payments in variable amounts as long as you meet a monthly minimum requirement. You pay interest only on the funds you borrow, and as you pay down your balance, your available credit is replenished.
Interest rates on personal LOCs can be significantly lower than those on credit cards. And since you only incur interest if you use the credit line, setting one up can be a good strategy for dealing with unplanned expenses that exceed your emergency savings or other resources.
Personal lines of credit have fixed durations, which encompass two distinct phases, each typically lasting three to five years:
- Draw period: During the initial draw period, you can freely borrow and repay money against your credit line.
- Repayment period: During the subsequent repayment period, you can no longer borrow against the credit line, and must repay the outstanding balance in a series of fixed monthly payments.
The lengths of the draw and repayment periods are spelled out in the terms of the letter of credit loan agreement.
Unsecured and Secured Lines of Credit
Lines of credit may be secured loans or unsecured loans. With a secured loan, you put up a personal asset as collateral, which the lender can seize if you fail to repay the loan. With an unsecured loan, the lender issues credit after reviewing your finances and credit history and determining you are likely to repay the loan. Unsecured credit is riskier for lenders than secured credit, so they typically charge higher interest rates and fees for unsecured credit lines.
Most personal lines of credit are unsecured, but there are two popular types of secured personal credit lines:
- A home equity line of credit (HELOC) allows you to borrow against the equity in your home—that is, the amount by which its appraised value exceeds the unpaid balance on your mortgage—and uses your home as collateral. You can typically borrow 60% to 85% of your home's equity. If, for example, you have paid off $200,000 in mortgage principal on a $500,000 mortgage, your unpaid principal equals $300,000; and if your home is appraised for $600,000, your equity would be that appraised value less the unpaid principal ($600,000 ᠆ $300,000), or $300,000. If a lender agreed to lend you 85% of your home equity, in this example, you could qualify for a HELOC of up to $255,000.HELOCs typically have draw periods of five to 10 years, followed by repayment periods of 10 to 20 years.
- A CD-secured line of credit uses money you have on deposit in a certificate of deposit (CD) as collateral. You may be able keep a CD-secured line of credit open for more than the three- to five-year spans that are common with unsecured personal lines of credit.
How Lines of Credit Compare with Personal Loans and Credit Cards
The most popular forms of unsecured loans available from financial institutions are lines of credit, personal loans and credit cards. Here's a look at their similarities and differences.
|Lines of Credit vs. Personal Loans and Credit Cards|
|Line of Credit||Credit Card||Personal Loan|
|Funds distribution||Revolving line||Revolving line||Lump sum|
|Payment type||Variable, monthly||Variable, monthly||Fixed, monthly|
|Account duration||Up to 15 years||Open-ended||24 to 60 months|
|Secured or unsecured||Both options available||Both options available||Unsecured|
|Interest charges||Interest is charged only on outstanding balance||Interest is charged only on outstanding balance||Interest charges are spread out across all payments|
|Loan Amount||$300 to $100,000 (unsecured); up to 85% of home equity (HELOC)||Up to $500,000 but $10,000 or less is more typical||Up to $100,000|
|APR range||8.25% to 17.74%||8.99% to 29.99%||4.99% to 35.99%|
Here are the main ways these forms of credit differ from one another:
- Lump sum vs. credit line: With a loan, the amount you borrow is delivered in a lump sum and you must start making monthly payments (including interest charges) immediately and continue for the duration of the loan—typically 24 to 60 months. With a LOC or credit card, you have access to a maximum amount of cash—your credit line or borrowing limit—but you don't pay interest or make payments until you use your credit.
- Payment amounts: A loan requires you to pay an identical amount every month for the life of the loan. With a credit line or credit card, you can pay back what you owe in payments of any amount at or above a specified monthly minimum. That means you can save on interest charges if you pay off your balance with a few large payments, or spread smaller payments out over a longer time span, and pay more in interest.
- Cost: It typically costs less to use than it does a credit card. Some personal lines of credit currently have interest rates of 8.25% to 15%. That compares to an average credit card interest rate of about 16.3% these days and average annual rates on two-year personal loans of 9.58%.
- Getting cash: It's much easier (and less costly) to get cash from a personal LOC or personal loan than from a credit card. With a personal loan, you receive a lump-sum cash payment, and with a personal credit line, you typically get a checkbook and a debit card you can use for purchases or cash withdrawals. Taking out a cash advance from a credit card can be much more expensive. Card issuers typically charge higher interest rates on cash advances than they do ordinary purchases, and many also charge additional fees on each cash advance.
- Length of term: You can keep a credit card account open indefinitely if you keep the card active and make payments as agreed, but loans and personal LOCs have fixed durations.
What to Do if Your Personal Line of Credit Is Closed
In recent months, some lenders have indicated a desire to stop offering unsecured personal lines of credit. If your lender informs you it is closing your personal line of credit, you should be aware that the action could adversely affect your credit score, even if you have no outstanding balance on the LOC. That's because closure of a credit line like the closure of a credit card account, lowers your total available credit. If you have an outstanding balance on your LOC or any other revolving credit account, less available credit increases your credit utilization—the percentage of your available credit represented by your outstanding balances. Utilization greater than about 30% can cause a significant decrease in your credit score.
If a lender plans to close your personal LOC, you have options for replacing this source of credit, including:
- Take out a new personal LOC at another financial institution. You may be able to get a personal credit line at another financial institution. If you do so, consider keeping the new account active by using it to make a small regular monthly payment, such as a media-streaming subscription or gym membership, that you can easily pay in full each month. Doing so can prevent the new LOC from being closed due to inactivity, without running up interest charges.
- Open a credit card account. As detailed above, this won't give you the same options as a personal LOC, and the interest charges are likely to be higher, but a credit card account with a borrowing limit close to that of your closed LOC can help you cover emergency expenses. It will also increase your available credit, and may offset some of the credit score damage caused by a rise in utilization. You can find cards you may qualify for using Experian CreditMatch™, which provides offers based on your unique credit profile.
How a Line of Credit Can Impact Your Credit Score
As with a card account, your management (or mismanagement) of a personal credit line can have a major impact on your credit scores.
If you run up a balance on a personal line of credit and fail to make a minimum monthly payment, your credit score could suffer significantly. Payment history is responsible for about 35% of your FICO® Score☉ , making it the most important scoring factor.
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 reduce your credit utilization. The amount you owe on your accounts is responsible for about 30% of your FICO® Score—and credit utilization factors heavily in that category.
When you apply for a personal line of credit, the lender typically conducts a credit check, which leads to a hard inquiry on your credit report. A hard inquiry can cause a short-term drop in credit score, which typically recovers in a few months as long as you keep up with your bills.
Opening a personal credit line can increase the variety of accounts you have on your credit report. Also known as credit mix, this factor accounts for about 10% of your FICO® Score.
If you want to see how a personal line of credit could affect your credit scores, consider signing up for Experian's free credit monitoring service, which will give you access to your credit report and FICO® Score and will alert you when your credit file changes.
The Bottom Line
A personal line of credit can be a valuable source of cash for emergencies or ongoing projects such as home repairs, and it can be a more affordable form of revolving credit than a credit card.