Definition of a Line of Credit

A line of credit is an unsecured loan whereby a bank agrees to give a borrower access to a set amount of money that he can tap as needed. The credit line can be a good option for both businesses and individuals who need access to extra cash periodically.

How It Works

Banks extend lines of credit to businesses or individuals they deem to be good credit risks. The bank will give the borrower access to a certain amount of credit that can be used as needed. The borrower pays interest only on the funds that are used. If the credit line is never tapped, the borrower pays only a nominal fee charged to retain access to the line.

Uses

Lines of credit, as Wells Fargo Bank puts it, offer a "simple and convenient way to help you handle fluctuations in your monthly cash flow." They can be used to pay for major purchases or bills, planned or unplanned. They're also a good way to consolidate multiple bills into one.

Advantages

Lines of credit have many advantages over other forms of loans. Unlike home-equity lines of credit (HELOC) or other secured loans, lines of credit don't require any upfront collateral. Unlike traditional loans, borrowers using lines of credit don't have to take all the money upfront. That saves on borrowing costs, which are only assessed as the credit is used.

Disadvantages

Because they're not secured, lines of credit usually involve higher interest rates than loans secured by a home or other collateral. Banks also usually won't lend as much if the loan isn't secured. For example, Wells Fargo will lend up to $100,000 for a personal line of credit, which might not be enough for certain expenses.

Credit Cards

In many ways, lines of credit work the same as credit cards, where a bank allows the borrower to charge expenses up to a set maximum. But credit lines typically have lower interest rates and higher available limits than credit cards. An advantage of a credit card, of course, is ease of use.