Life is full of curveballs that can throw your finances into a danger zone if you're not prepared. An unexpected medical expense or car repair that you don't have the cash to cover is stressful enough. What can make it even worse is that some of the common ways to come up with the cash to pay bills, such as charging it to a credit card that you will pay off over time, can be very costly.
Setting up a line of credit today can be a smart way to be better prepared to deal with an expenditure that you can't pay for in full.
A line of credit is an account you can have with a bank or credit union that allows you to borrow money when you need it, up to the preset limit for the line. Interest is only charged once you borrow money. When you pay back any borrowed funds, your available credit line is replenished.
If you have a high credit scores, a line of credit can be a less expensive option than running up an unpaid credit card balance or taking a cash advance on a credit card. Yet less than one in 10 households that have less than $400 saved up to handle surprise expenses say they would use a bank line of credit, while more than four in ten say they would use a credit card.
The Costs of Borrowing Money
Some unsecured lines of credit currently have interest rates of 10% or so for borrowers in solid financial shape. That compares to an average credit card interest rate of around 14% these days:
Taking out a cash advance from a credit card can be an even more expensive way to cover expenses. The average interest charge is more than 23% for a cash advance. That fee is charged immediately; even if you pay off the advance in a few days or weeks you are still on the hook for the upfront charge. Moreover there is often a stiff upfront fee of 5% or so of the advance.
Line of Credit 101
Loan v. Line
When you borrow money from a bank, credit union, or online lender, you have two broad options. With a loan you get a lump sum payment upfront payment and you begin paying interest on that sum immediately. With a line of credit you have access to a set amount of money—your credit line limit—but until you actually tap any of that money there is no interest charged. A line of credit is yours to tap on an "as needed" basis.
Line of Credit: Secured v. Unsecured
Typically, a personal line of credit is "unsecured." This means you do not use any asset as collateral for the line. That means that if you fail to pay back the line of credit, there are no other assets of yours the lender has a right to claim. That's different from a secured loan. For instance, a car loan is a secured loan, with the car being the collateral. If you fail to make payments, the lender can seize the car and re-sell it.
A Home Equity Line of Credit (HELOC) is a type of secured line of credit. Qualified homeowners can open a HELOC and tap it as needed, to cover unexpected expenses, or anything for that matter. Tuition bills. Vacations. Remodeling projects. That said, it is important to understand that the collateral for a HELOC is your home. If you tap your HELOC and then aren't able to keep up with repayments, defaulting on your payment obligation could lead to your losing the house through foreclosure.
Unsecured Personal Line of Credit
You can apply for a personal line of credit at a bank or credit union. There are also online lenders that offer lines of credit.
- Your Credit Scores Come into Play. Your credit scores will be a major factor in determining if 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 can help you qualify for a better line of credit deal.
- Line Limits Vary from Lender to Lender. Some lines of credit are limited to $15,000 to $30,000 or so, while some banks offer credit lines that stretch to six figures for qualified clients that also have savings accounts at the bank.
- The Variable Rates Can Change. The interest rate on a line of credit can change over time. The variable rate is tied to a financial benchmark index or interest rate. As that rate changes, so too will the interest rate you owe on your line of credit.
- The Line Is Open for Just a Few Years. An unsecured line of credit typically has a fixed "draw" period. This is the amount of time you have to use the line. The draw period might be three to five years. During the draw period, your line of credit is "revolving." When you repay any used portion, your available line of credit is replenished by the amount of your payment (up to your preset limit).
After the draw period any balance must be repaid. The repayment time will be set when you open the line. Three to five years for repayment is common.
There are typically no big upfront fees to apply for a personal line of credit. Some lenders might charge an annual fee of $25-$50 or so.
Secured Line of Credit
Home Equity Line of Credit (HELOC)
Homeowners can create a line of credit based on the "equity" in their home. Equity is the appraised value of a home that exceeds the unpaid principal balance on a mortgage. Lenders tend to offer HELOCs to homeowners when their mortgage principal balance is no more than 80% or so of the appraised value of their home. In mid-2017 there were nearly 16 million HELOC accounts with a value of more than $450 billion.
- Your Home Is on the Line. It bears repeating that your home is the collateral, so you want to carefully consider whether this makes sense for you, or what expenses you would consider using a HELOC to pay for.
- Lenders Will Check Your Credit Scores. The higher your credit score, the better deal you will be offered. Lenders typically prefer to offer HELOCs to borrowers with excellent credit scores.
- Variable Interest Rate. Most HELOCs have an interest rate that can change over time. Right now the average HELOC rate is below 6%. Just keep in mind that if you tap a HELOC and rates rise, your interest payments will be higher. Some lenders are now offering HELOCs where you can convert the used balance to a fixed interest rate.
- Interest Is Tax Deductible. If you file an itemized federal tax return, the interest payments on a HELOC of up to $100,000 can qualify for a deduction.
- Terms: Most HELOCs have a 10-year draw period, where you can tap your line of credit. After the draw HELOC balances must be repaid. Some HELOCs have a 10 to 20 year period, but read the fine print before you take out a HELOC. Some HELOCs demand a sudden "balloon" payment—for the entire unpaid balance-once the draw period ends.
- Low Fees. Compared to the closing costs you paid when you took out a mortgage, a HELOC is inexpensive. Some lenders might charge $50 to $100 for an application or origination fee. Some also charge an annual fee of $50. In some instances you may also need to pay for a formal home appraisal.
Personal Secured Line of Credit
Money you have on deposit in a savings account, or in Certificates of Deposit (CDs) can be used as collateral for a line of credit. Because the line is secured, the interest rate is typically lower than the interest rate on an unsecured line of credit, and you may be able to open a secured line of credit for more than the typical three to five years that is common with unsecured personal lines of credit.
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.