Lines of credit are a form of credit issued by some lenders. A maximum amount of credit is set when the line of credit is created, and the customer can borrow against the line of credit up to this maximum amount. Borrowers who are more familiar with standard loans and credit cards may be left with some questions regarding the use of a line of credit.
How Does a Line of Credit Work?
A line of credit account functions similarly to a checking account, with the value of checks written adding to the amount that has been borrowed against the credit line. Checks can be written against the account until the amount reaches the maximum loan amount for the credit line. As payments are made on the account, more credit becomes available for use so that additional checks can be written as needed. If the lender does not have the full amount of money necessary to honor the line of credit, it may reduce the limit of the line as needed.
What Are the Advantages of Lines of Credit?
Lines of credit allow borrowers to spend money over time, borrowing additional money when they need it. This typically is used to pay for projects that require multiple purchases from different locations or purchases over a period of time. The borrower is only responsible for the amount of money he spends, unlike a traditional loan, which requires repayment of the full loan amount regardless of whether the entire loan was needed.
How Is Interest Charged on a Line of Credit?
Interest on a line of credit may be charged at either a fixed or variable rate. Interest is only charged on the amount of the line of credit that has been used, not on the maximum amount that can be borrowed using the credit line. Depending on the lender, an introductory interest rate may be offered that applies for the first few months after the line of credit is established. Once the introductory period ends, the interest rate increases.
How Is a Line of Credit Repaid?
Lines of credit require monthly payments like most other loan and credit products. A minimum payment must be made, though larger amounts typically can be paid without penalty. Similar to the credit lines used for credit cards, making payments on a line of credit typically allows the repaid money to be borrowed again. Lines of credit have a set date by which they must be repaid, after which no additional money can be borrowed unless an extension is granted by the lender.
Are Lines of Credit Secured or Unsecured?
A line of credit can be either secured or unsecured. The difference between the two types is whether the lender requires property or assets to be offered as collateral. The use of collateral acts as security for the credit line and reduces the risk for the lender, because the lender can claim the collateral if the borrower doesn't repay what is owed. Standard lines of credit are typically unsecured, though collateral may be required if the borrower has an unsatisfactory credit score.
What Is a Home Equity Line of Credit?
A home equity line of credit (HELOC) is a credit line that is secured using the equity in a person's home. Home equity lines of credit often are used as an alternative to second mortgages, because the borrower can take advantage of the fact that he only has to repay the money he uses instead of repaying the full loan amount.
Are Lines of Credit Only for Individuals?
Lenders can extend lines of credit to both individuals and businesses. Business lines of credit may be charged a higher interest rate, but they typically have a higher maximum amount that can be borrowed as well. Businesses may use a line of credit during startup or expansion to pay for supplies and other business costs, or it may keep a running line of credit to ensure that all suppliers and contractors are paid on time regardless of cash flow issues.
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