Line of Credit – Definition, Types, Pros & Cons

What is a Line of Credit?

A line of credit is a form of loan that allows borrowers to borrow a set amount of money and utilise it as per their financial requirements. It is different from a traditional loan, where the borrower receives a lump sum of money all at once and must pay it back over a set period. Instead, a line of credit allows the borrower to draw on the credit as needed, up to the credit limit. The borrower pays interest only on the credit that is utilized.

Lines of credit are classified into three types:

• Revolving lines of credit
• non-revolving lines of credit
• home equity lines of credit (HELOCs).

Revolving lines of credit are similar to credit cards, where the borrower has a credit limit and can use the credit as needed, up to the credit limit. Non-revolving lines of credit are more like traditional loans, with a fixed amount of credit and a set repayment period. HELOCs are home equity lines of credit that permit the borrower to utilize the equity in their home as security.

Borrowers must often disclose personal and financial information, such as their employment history, income, and credit score, when applying for a line of credit. The lender will use this information to determine the borrower's creditworthiness and the credit limit for the line of credit. Once approved, the borrower can access the credit as needed, using a credit card, check, or online banking. Minimum monthly payments, which may include interest and fees, are required of the borrower.

Types of Lines of Credit

Following are the various types of lines of credit:

• Revolving line of credit: The most prevalent sort of credit line. It bears some resemblance to a credit card in that the borrower has a credit limit and can utilize the credit as required up to that amount. The borrower is expected to make minimum payments each month but can compensate more money if they like.
• Non-revolving line of credit: This type of line of credit is similar to a traditional loan, where the borrower is given a fixed amount of credit and must pay it back over a set period of time. The borrower is required to make regular payments, typically monthly, until the loan is paid off.
• Home equity line of credit (HELOC): This is a form of a line of credit that is backed by the borrower's home. It enables the borrower to use their property as collateral as security for the line of credit. This sort of credit is frequently used for home debt consolidation or during some emergency fund need.

How Does a Line of Credit Work?

When a borrower applies for a line of credit, they are typically required to provide some personal and financial information, such as their income, employment history, and credit score. The lender will use this information to determine the borrower's creditworthiness and the credit limit for the line of credit.

Once the line of credit is approved, the borrower can access the credit as needed, up to the credit limit. The borrower can use a credit card, cheque, or online banking to make purchases or withdraw cash. Monthly minimum repayments, which include interest and fees. The borrower can avail funds but has to fix a monthly instalment to pay back.

You may also read this: Factors that affect credit score

Advantages and Disadvantages of a Line of Credit:

Advantages of a Line of Credit

Flexibility: A line of credit allows the borrower to access credit as needed, rather than receiving a lump sum all at once. This can be especially useful for unexpected expenses or for funding a project that will be paid for over time.

Lower interest rates: One of the greatest advantages of a line of credit is the lower and more affordable interest rate that it carries. Lines of credit typically have lower interest rates than credit cards.

Credit building: Using a line of credit responsibly and making timely payments can help improve the borrower's credit score.

Disadvantages of a Line of Credit

Here are some disadvantages of using a line of credit to meet finance needs:

Fees: Some borrowers do charge some fees on the line of credit. This fee can vary from borrower to borrower. The fees include transaction fees, processing fees, and much more. Thus, you will have to consider fees and add them to the cost of borrowing when analysing a line of credit.

Credit limit: Well, when it comes to a line of credit, the borrower needs to stick to the credit limit. There is a certain credit limit that a borrower is entitled to. If one wants to avail of an amount exceeding the credit limit, one must opt for traditional borrowing options, such as a loan.

Interest: In the line of credit, the borrower pays only for the amount utilised by him/her. If the borrower fails to make the monthly payment on time, the interest will quickly add up, and the borrower will have to pay a large sum.

How to Choose the Right Line of Credit?

Selecting a line of credit can be a complex and daunting task that may demand a lot of research and attention to detail. Comparing different line of credit options and researching various parameters will help one to select the most suitable line of credit.

Here are some points that will help you choose the right line of credit:

• Interest rate: Compare the interest rates of different lines of credit to find the one with the lowest rate. A lower loan amount can have a higher rate of interest, and so on. One must research thoroughly to get the most competitive rate of interest.
• Credit limit: A lender must consider the credit limit and the requirement of the emergency funds in order to make sure that the loan amount can efficiently meet the fund requirement. It should also be noted that the higher the loan amount or credit limit, the higher the interest rate.
• Fees: Look for a line of credit that has minimal fees, such as annual fees or transaction fees.
• Repayment terms: Repayment terms are crucial. It is essential to have a clear understanding of the same before opting for a line of credit. The repayment terms are determined by a variety of factors, including the interest rate, loan tenure, loan amount, instalment amount, and many others. One must agree to the loan repayment terms. If the loan repayment terms are not flexible or as expected, one must try to speak to the lender and finalise the repayment terms.
• Security: If you are considering a secured line of credit, such as a home equity line of credit, make sure you are comfortable using your home as collateral. Remember that if you default on the loan, you may lose your home.
• Lender: One must select a lender who has a good reputation in the market. The lender must be able to deliver fair satisfaction to its customers. Moreover, ensure that the terms, conditions, and policy of the lender are easy to comprehend and transparent. One must be well acquainted with the borrowing process and must access the credit before making a final decision.

Using a Line of Credit Responsibly

To get the most benefit from a line of credit and avoid financial problems, it's important to use it responsibly:

• Only borrow what you can afford to pay back: Don't overextend yourself and borrow more than you can comfortably afford to pay back.
• Make on-time payments: To avoid late fines and keep your credit score in good standing, make your minimum monthly payments on time.
• Pay more than the minimum: If you can afford it, attempt to pay higher than the minimum each month to pay off the amount quicker and decrease the interest payments.
• Monitor your balance: Keep track of your balance and try to pay off as much as possible each month to avoid accruing too much interest.
• Use it wisely: A line of credit is a useful tool for managing unexpected expenses or funding a project, but it should not be used to finance unnecessary or impulsive purchases. Use it wisely and only for truly necessary expenses.

Conclusion

A line of credit is a useful financial tool that can provide access to credit as needed. It can be a cost-effective option for borrowing, but it's important to choose the right line of credit and use it responsibly to avoid financial problems. By considering factors such as interest rate, fees, repayment terms, and lender reputation, and by using the credit wisely and making timely payments, you can make the most of a line of credit and achieve your financial goals.