Lines of Credit: When to Use Them and When to Avoid Them

When you need money, you may consider getting a personal loan, which provides a lump-sum amount. However, if you don’t know exactly how much money you may need, you may want to consider a line of credit.

A line of credit is a revolving loan that allows you to access money as you need it up to a certain limit. You can borrow up to that limit again as the money is repaid. Learn more about what a line of credit is, about the different types, when to avoid them, and how to use them to your advantage.

What Is a Line of Credit?

A line of credit is a flexible loan from a bank or financial institution. Similar to a credit card with a set credit limit, a line of credit is a defined amount of money that you can access as needed and use as you wish. Then, you can repay what you used immediately or over time.

As with a loan, you will pay interest using a line of credit. Borrowers must be approved by the bank, which considers credit rating and/or your relationship with the bank, among other factors. Lines of credit tend to be lower-risk than using a credit card, but they are not as common.

A line of credit can be secured or unsecured. If you offer an asset you own as collateral for the line of credit, you'll pay a lower rate than if you were to offer the lender nothing they can potentially take from you in the case of default.

Unlike with personal loans, the interest rate on a line of credit is generally variable, meaning it could change as broader interest rates change. This can make it difficult to predict what the money you borrow will end up costing you.

When a Line of Credit Is Useful

Lines of credit are not intended to be used to fund one-time purchases such as houses or cars, though they can be used to acquire items for which a bank might not normally underwrite a loan. Most commonly, individual lines of credit are intended for unexpected expenses or to finance projects that have unclear costs.

Problems With Lines of Credit

Like other loan products, lines of credit have benefits and risks to consider. Firstly, if you have poor credit, you may not even get approved for this product. And, if you do, you'll have to pay the money back and make sure you can afford to make those repayments.

Some banks will charge a maintenance fee (either monthly or annually), even if you don't use the line of credit, and a transaction fee every time you draw money. And interest starts accumulating as soon as money is borrowed. Because lines of credit can be drawn on and repaid on an unscheduled basis, some borrowers may find the interest calculations for lines of credit more complicated. You could be surprised at what you end up paying in interest.

The cost of borrowing money can be expensive, particularly if you take out a personal line of credit that is unsecured. Offering lines of credit without collateral is riskier for lenders and that generally means higher interest rates and greater difficulty getting your request for credit accepted.

The alternative is also risky. Home equity lines of credit (HELOCs) use your home equity as collateral. This reduces borrowing costs but means if you default on payments the bank or financial insutition has the right to take possession of your home. In other words, you could end up homeless.

Comparing Lines of Credit to Other Types of Borrowing

Lines of credit have similarities and differences compared to other financing methods like credit cards, personal loans, and payday loans.

Credit Cards

Like credit cards, lines of credit have preset limits in that you are approved to borrow a certain amount. Also, like credit cards, policies for going over that limit vary with the lender. Also similar to a credit card, a line of credit is essentially preapproved, and the money can be accessed whenever the borrower wants for whatever use. Lastly, while a credit card and a line of credit may have annual fees, neither charges interest until there is an outstanding balance.

Credit cards will always have minimum monthly payments, and companies will significantly increase the interest rate if those payments are not met. Lines of credit may or may not have similar immediate monthly repayment requirements.

Personal Loans

Like a traditional loan, a line of credit requires acceptable credit and repayment of the funds and charges interest. Also like a loan, using a line of credit responsibly can improve a borrower’s credit score. You can use funds from personal loans and lines of credit for any purpose you like.

There are also several differences between these products. For example, a loan is typically for a fixed amount for a fixed time with a prearranged repayment schedule. In contrast, a line of credit has more flexibility and usually has a variable rate of interest. When interest rates rise, your line of credit will cost more, whereas payments for a fixed loan remain the same.

Payday and Pawn Loans

There are some similarities between lines of credit and payday and pawn loans, including the fact that you can use the funds as you wish. The differences, however, are considerable:

• For anyone who can qualify for a line of credit, the cost of funds will be dramatically lower than for a payday or pawn loan.
• The credit evaluation process is easier with a payday or pawn loan (there may be no credit check at all), and you get your funds more quickly.
• A line of credit is generally much larger than a payday or pawn loan.

The Bottom Line

Lines of credit, like any financial product, have advantages and disadvantages, depending on how you use them. On one hand, excessive borrowing against a line of credit can get you into financial trouble. On the other hand, lines of credit can be cost-effective solutions to fund unexpected or major expenses.

As is the case with any loan, shop around and pay careful attention to the terms—particularly the fees, interest rate, and repayment schedule.