All About Line of Credit


What is a line of credit?

A line of credit (LOC) is a pre-set amount which you can avail of from a bank or financial institution. It is a revolving credit which allows you to draw the required amount until the credit limit is reached. You can repay the borrowed sum immediately or after a specified time to free up additional credit. The interest rate of LOC is variable and is levied only on the sum borrowed, which means you cannot predict the cost of your LOC borrowing. Thus, a line of credit works like a credit card where you can borrow until you exceed the maximum credit limit. Also, after repaying the sum, you can borrow again under the same line of credit account.

KEY TAKEAWAYS

  • A line of credit is a flexible borrowing mechanism with a revolving credit cycle.
  • You can borrow from the specified credit limit according to your cash flow needs.
  • Types of the LOCs are secured, unsecured, revolving and non-revolving.
  • The advantages of LOC include the availability of funds in times of need and no collateral requirement in most LOCs.
  • The drawbacks of LOC are high-interest rates, penalties on late payments, chances of overspending, difficulty in approval, etc.
  • Examples of LOCs: Business LOC, personal LOC, home equity LOC, demand LOC and securities-backed LOC.
  • Before opting for a LOC, remember to consider your credit needs, the APR of the lender and your repayment ability.

Types of Line of credit

LOCs are of several types which are as follows:

1. Revolving vs non-revolving LOC

A regular loan allows you to borrow a fixed amount in a lump sum, which you have to repay in monthly instalments over a period. Once the loan is repaid, you cannot avail of funds under the same loan again. For that, you need to apply for a new loan. However, in a revolving LOC, you can borrow any amount within your credit limit, repay it and borrow again which leads to a revolving and never-ending cycle. Thus, a revolving LOC is also called an open-end credit.

A non-revolving line of credit works like a revolving credit. A non-revolving LOC allows you to borrow a pre-decided sum over a period which you have to pay back with interest. However, there is a difference—unlike a revolving LOC, you cannot avail of funds again once you have repaid the entire non-revolving LOC amount. After the repayment, your LOC account gets closed.

2. Secured vs unsecured LOC

Usually, a line of credit is an unsecured loan, which is not backed by collateral. However, in the absence of collateral, an unsecured LOC is riskier for the lender and thus difficult to procure. So, to avail of an unsecured LOC, your credit rating must be high. Also, the financial institution will charge a higher interest rate in the case of unsecured LOC due to the lack of security offered by the collateral.

However, a Home Equity line of credit (HELOC) and a secured business loan are exceptions. Here the collaterals are the equity in your home or business inventory/equipment. Compared to unsecured LOC, secured LOC is less risky for the lender due to the availability of compensation in case of missed or non-payments.

Advantages of LOC

A line of credit has several advantages that are as follows:

  • A line of credit is an efficient tool for businesses and households to ensure the availability of cash flows during temporary cash flow issues. It also helps in financing projects with unpredictable costs.
  • The LOC mechanism leads to a stable cash flow without tapping into your savings.
  • As long as your LOC account is open, you can access the funds whenever needed.
  • Most of the LOCs are unsecured loans with no need for collateral.

Disadvantages of LOC

While there are multiple advantages of LOC over a regular loan, you must also know the disadvantages of the borrowing mechanism which are as follows:

  • The main disadvantage of a LOC is the varying interest rates and maximum sum available. You cannot predict the actual costs of your borrowing amount as the lender can increase the APR in the future.
  • Usually, most LOCs are unsecured. With no collateral required, the instruments have higher interest rates than traditional loans.
  • Late payments in a LOC can invite stricter penalties. Also, a maintenance fee is charged by some banks if the line of credit is not used.
  • There is no grace period in a line of credit. Unlike a credit card, the interest is charged the moment you withdraw the amount.
  • For LOC borrowings, your credit score and history must be strong over the past 5-7 years. A poor credit score will give you a hard time while getting approval.

Examples of LOC

Following are examples of the line of credit:

1. Business LOC

A Business line of credit is availed in place of fixed loans for several business purposes. With variable interest rates, a Business LOC is granted after evaluating the market value and profitability of the business. Also, the loan is of secured or unsecured nature depending on the business profitability, value, credit score, and the amount of the credit. A secured Business LOC includes collateral in the form of business inventory or equipment. However, an unsecured Business LOC doesn’t require collateral. But it is more expensive than the secured Business line of credit due to the lack of security.

2. Personal LOC

A Personal LOC allows you to borrow an amount within the credit limit without any collateral. Once you repay the borrowed amount, you can again borrow during the draw period. Thus, a Personal line of credit is a flexible instrument that keeps on revolving. It comes in handy for financial needs, such as home renovation, your child’s education, wedding, etc. With no need for collateral, the amount is given after evaluating your income, expenses, and credit history. Getting approval for a Personal LOC can sometimes become difficult due to the lack of security.

3. Home Equity LOC

Similar to a Personal line of credit, HELOC offers a predetermined amount over a specified period. It is the collateral requirement that distinguishes the two. The loan amount depends on the equity you have in your home, your credit score and your income. Like Personal LOC, the interest and the monthly payments begin when you make your first withdrawal. Interest rates in a HELOC are variable that fluctuate during the LOC term. However, they are lower than other LOCs due to a decline in the lender’s risk because of the presence of collateral.

4. Demand LOC

A Demand LOC is either secured or unsecured under which you can borrow up to your credit limit at any time. However, in a Demand LOC, the lender can demand the borrowed sum which is due anytime. Depending on the LOC terms, the lender can demand a payback with interest only or interest with the principal.

5. Securities-backed LOC

Securities-backed LOC is a LOC where your securities act as the collateral. The LOC allows you to avail of loans varying from 50-90% of the asset value. You can use the borrowed amount for any purpose and have to repay the sum with interest. A brokerage or bank demand payment is also required if your portfolio value declines below the LOC value.

LOC vs other types of loans

A line of credit is more beneficial than some loans. However, it has drawbacks too when compared to other borrowing mechanisms. Let’s find out.

1. Traditional loan vs LOC

A traditional loan offers a fixed lump sum amount at fixed interest rates for a specific period. Also, traditional loans are provided for specific purposes, such as buying a car or home or pursuing an education. However, a line of credit has no restriction on the use of the borrowed sum. Compared to a traditional loan, a LOC is a flexible mechanism in which you can borrow any sum within the credit limit according to your cash flow needs. As long as your LOC account is open, you can avail of funds multiple times with the promise of repayment along with interest. However, one of the disadvantages of LOC against traditional loans is the varying interest rate during the credit tenure.

2. Credit card vs LOC

A credit card and line of credit are very similar in terms of credit limit, repayment, application of interest, and flexibility features. Like a credit card, you can borrow the desired sum whenever you wish, with interest charged only on the sum borrowed. However, the main difference between the two is the security of repayment. A LOC can be secured with property in case of home equity loans. Business loans can also be secured depending on the credit limit. But no collateral is required for credit cards, making them risky for the lender. Moreover, a LOC is approved through an evaluation of your credit history, income and expenses. Also, the interest rate of LOC is lower while the credit limit of LOC is higher than credit cards.

Points to consider before applying for LOC

Before you apply for a line of credit to meet several liquidity needs, consider the following points:

  • Evaluate your credit needs

Before applying for a LOC, make sure you have evaluated your credit needs. Consider the worst-case scenario of a cash crunch and choose the amount limit accordingly. However, choosing a limit more than you need may tempt you to spend more, causing issues in repayment. Thus, evaluate your income and expenses and choose a suitable sum.

  • Factor in the APR

APR is the Annual Percentage Rate, which refers to the interest charges, annual fees, maintenance fees, transaction fees, etc. APR in line of credit varies according to the lenders and the borrower’s creditworthiness. So, before opting for a LOC, consider the APR factor and its impact on your repayments.

  • Evaluate your repayment ability

Before choosing a suitable LOC amount, you must evaluate your monthly repayment ability. For this, you should consider your monthly expenses and income to ensure repayments are made on time to avoid penalties.

Final words

A line of credit is an efficient borrowing tool to ensure the availability of cash for unexpected business or household needs. However, before you consider applying for a line of credit, you must ask yourself why you want to borrow through a LOC, as the interest rates are higher than a traditional loan. Also, do not forget to compare the LOCs provided by different lenders to make an informed and cost-effective choice.

Other Words

  • Late payment
  • Loan Agreement

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