Flexible access to funds is a great convenience when managing cash flow. This is where a line of credit can be beneficial. A line of credit provides access to funds whenever you need them, and you are charged interest only on the amount you withdraw rather than on the total approved credit limit.
Understanding what a line of credit is can help you choose the right financing option to meet your short- and long-term financial needs.
Line of Credit Meaning
A Line of Credit (LOC) is a pre-approved amount of money you can borrow whenever you need to. A line of credit is a "Revolving" type of credit product provided by a lender. Unlike a traditional loan, you won’t receive the entire amount at once. You can withdraw money from the line of credit into your bank account anytime you need it.
You can borrow from the LOC, repay the outstanding balance according to the lender’s terms, and borrow again as funds become available. Because of this flexibility, using a Line of Credit (LOC) is a great way to finance your expenses.
How Does a Line of Credit Work?
Before exploring the different types of lines of credit, it is important to understand the mechanism. The lender determines your credit limit based on factors like credit score, income level, total amount of debt, and repayment history. Once you have been approved, you can withdraw funds as needed until you reach your credit limit.
For example, if you have been approved for a credit limit of ₹3 Lakh and have withdrawn ₹50,000, you generally need to pay interest only on the ₹50,000 used. The remaining ₹2.5 Lakh stays available for future withdrawals, subject to the terms and conditions of the line of credit.
Types of Lines of Credit
There are different types of credit lines to accommodate different borrowing needs.
Personal Line of Credit
You may borrow funds, pay them back, then re-borrow up to the maximum limit. With a private credit line, you have the flexibility to finance both planned and unexpected expenses. A personal line of credit can be used for:
- Emergency medical expenses
- House repairs
- Education-related expenses
- Travel-related expenses
Only the amounts that have actually been borrowed are subject to interest charges.
Business Line of Credit
Certain businesses might prefer borrowing on an as-needed basis rather than taking out a fixed loan. Such companies most commonly opt for a business credit line to manage working capital needs.
Some of the common uses of a business credit line include:
- Inventory purchases
- Supplier payments
- Payroll
- Seasonal cash flow gaps
Business credit lines offer financial flexibility through the ups and downs of your business cycle.
Home Equity Line of Credit (HELOC)
The primary factor determining the borrowing limit is the value of the collateral. A home equity line of credit, commonly known as a line of credit HELOC, allows borrowers to access funds using home equity as collateral.
The amount of available credit is generally based on the home’s market value, the borrower’s equity in the property, and the lender’s policies.
Securities-Backed Line of Credit
A Securities-Backed Line of Credit (SBLOC) allows borrowers to use eligible investment assets as collateral to access liquidity without selling those assets. The permitted uses of funds depend on the lender’s terms and conditions.
Demand Line of Credit
A demand line of credit is an uncommon type of line of credit. It gives the lender the right to demand payment at any time. The lender can make a demand for payment based on the terms of the agreement.
Secured and Unsecured Lines of Credit
It is essential to understand the difference between secured and unsecured credit. A secured line of credit is backed or secured by the use of collateral, which can include either property or investments. An unsecured line of credit does not have to be backed or secured by a piece of collateral.
Benefits of a Line of Credit
Before applying for a line of credit, it is essential to be aware of some of the advantages available to you.
Flexible Borrowing
A line of credit allows for flexible borrowing; thus, you can access funds as needed. You only borrow what you need, rather than borrowing the entire amount at the beginning for a large loan.
Interest on Utilised Funds Only
Interest is generally charged only on the amount withdrawn, although fees and other charges may also apply, depending on the lender.
Quick Access to Funds
Once approved, funds can often be accessed quickly during the available draw period.
Multiple Usage Options
Depending on the lender and product type, funds may be used for a wide range of personal or business purposes, subject to any applicable restrictions.
How Does a Line of Credit Affect Your Credit Score?
A line of credit is assessed by the credit bureaus and treated the same way as any credit card or Personal Loan. A Line of Credit impacts your credit rating by:
- Timely payments
- Credit utilization
- Outstanding balance
- Length of credit history
If you make your payments late, it negatively affects your payment history. Responsible borrowing habits support a healthy credit history. Hard inquiries made during the application process may also have a temporary impact on your credit score.
What is the Repayment Process of a Line of Credit?
The payment process for a line of credit is similar to that of repaying a credit card. Borrowers generally repay:
- Principal amount
- Interest charges
- Applicable fees
For example, if you are approved for a line of credit of ₹2 Lakh and withdraw ₹20,000, interest is generally charged only on the ₹20,000 withdrawn. As you repay the outstanding amount, your available credit limit is restored and can be used again, subject to the lender’s terms and conditions.
How to Apply for a Line of Credit?
Generally, applying for a line of credit includes the following steps;
- Evaluate lenders and products.
- Review the eligibility requirements.
- Fill out the application form.
- Provide required documentation.
- Let your lender evaluate your creditworthiness.
- Receive your approval and credit limit.
To evaluate your creditworthiness, lenders look at your credit score, repayment history, income and other outstanding debts before issuing a line of credit.
To Conclude
A Line of Credit (LOC) provides a flexible way to borrow money and access funds for personal or business use. Unlike a standard loan, a LOC allows borrowers to withdraw funds as needed and pay interest only on the amount they have used. Personal, business, and home equity Lines of Credit are common examples, and these may be either secured or unsecured.
Understanding how a LOC works, how repayments are calculated, and how it may affect your credit score can help you make informed borrowing decisions.
Read Also: Outstanding and Overdue Payments - Everything You Should Know
FAQs
Is a line of credit better than a credit card?
A line of credit generally offers a higher credit limit and lower interest rates than a credit card. However, the better option depends on your borrowing needs and spending habits.
What determines the credit limit on a line of credit?
The credit limit is typically determined by factors such as income, credit history, credit score, existing debt obligations, and the lender’s policies.
Can I use a line of credit for business expenses?
Yes, a business line of credit can be used for inventory purchases, working capital requirements, payroll, or other operational expenses.
Does a line of credit require collateral?
Not always. Secured lines of credit require collateral, while unsecured lines of credit do not.
Can I reuse a line of credit after repayment?
Yes. Most revolving lines of credit allow you to borrow funds again up to your approved credit limit once the outstanding balance has been repaid.
We take utmost care to provide information based on internal data and reliable sources. However, this article and associated web pages provide generic information for reference purposes only. Readers must make an informed decision by reviewing the products offered and the terms and conditions. Loan disbursal is at the sole discretion of Poonawalla Fincorp.
*Terms and Conditions apply