Having access to credit can give you immediate financial leverage. It can come in handy when purchasing a big-ticket item, paying off high-interest debt or a medical bill, or sprucing up your home.
If you have a high credit score and are considering tapping into a line of credit, there are a few key things to know. Read on to learn more.
What is a line of credit and how does it work?
A personal line of credit is a type of revolving loan. In other words, you are given a credit limit from which you can draw. You can borrow up to that amount and continue withdrawing from it -- as long as you repay what you borrow. Though personal lines of credit offer some flexibility, there are some guidelines:
- Loan amounts. The maximum amount offered depends on the lender, but LOCs typically run between $1,000 and $100,000. Your maximum loan amount, terms and rates depend on a handful of factors, such as your creditworthiness and risk profile.
- Draw period. Unlike credit cards, personal lines of credit have a defined draw period. This is a fixed timeframe in which you can borrow money from your loan. Interest starts to accrue as soon as you withdraw money from your personal line of credit.
- Repayment period. This is when repayment is due. Once the repayment period kicks in, you won’t be able to take any more money out until you pay back what you owe. In some cases, a personal LOC may require a balloon payment at the end of the draw period, which requires repaying the total amount borrowed in one lump sum.
Personal lines of credit versus personal loans
While they sound similar and do share similarities, a personal loan is a lump sum you receive up front. A personal line of credit is a type of revolving loan, but a personal loan is a type of installment loan. What this means is that you make payments over time in installments. Like a personal line of credit, personal loans do bear interest fees.
Secured versus unsecured lines of credit
Typically, a personal line of credit is unsecured. This means it’s not backed by collateral such as a car or home. A secured line of credit is backed by collateral.
The obvious advantage of an unsecured line of credit is that you don’t need to offer up -- and risk forfeiting -- a major asset to get the loan. Because they’re seen as riskier than secured loans, however, interest rates tend to be higher and the credit score requirements tend to be higher.
Secured lines of credit tend to have lower interest rates and are easier to obtain. You typically don’t need as high a credit score as unsecured lines of credit. The biggest drawback is that you’ll first need to have an asset you can offer as collateral and you’ll need to be comfortable with that arrangement.
Advantages of personal credit lines
- Helpful if you have upcoming expenses, but do not know exact amounts. One of the best features of a personal line of credit is its flexibility, explains Michelle Lambright Black, a credit expert and founder at CreditWriter.com. “This comes in handy when you don’t know exactly how much money you need to borrow for a project,” says Black. “For example, with home repairs and home improvement projects that you’ll complete in incremental steps, you may not know the final cost in advance.”
- Ability to withdraw only what you need. Another major advantage of a personalline of credit is that you can take out amounts at a time. “Personal lines of credit may serve you better than credit cards in situations where you need flexible access to cash,” says Black. “Although a credit card may give you the ability to request cash advances, the associated fees tend to be quite expensive.”
- Fast access to funds. Once approved, some online lenders can provide access to funds in as little as one business day.
- Lower rates than credit cards. The rates for a personal line of credit vary, but typically range between 9.30% to 17.55% variable APR, which is lower than most interest rates on credit cards. The stronger your credit score, the better rate you’ll be eligible for.
- Potential for less overall debt. Because you have the freedom to borrow only as much as they need, it could result in less debt in the long run, says Black.
Risks of personal credit lines
- Harder to qualify for. Personal credit lines can be tougher to qualify for than secured loans.
- Higher rates than other lines of credit. Unsecured personal lines of credit tend to have higher interest rates than many fixed-rate loans and secured lines of credit.
- The interest you pay isn’t tax deductible. The interest you pay on a personal line of credit isn’t tax-deductible. However, interest you pay on a home equity line of credit, or HELOC, is tax-deductible, as long as the money from the loan is used to buy, build, or improve a home.
- Variable interest rates. Like credit cards, personal lines of credit have variable interest rates, which are tied to the prime rate. That means that the interest you pay can fluctuate.
What’s the difference between lines of credit and credit cards?
Both are revolving loans: You have a credit limit and you repay as you go. And they’re both unsecured. The key difference is that a line of credit typically has a lower interest rate than a credit card as well as an initial draw and repayment period. Once this repayment period starts, then you won’t be able to draw from your LOC. A credit card will have a maximum spend limit, but you can keep spending -- without paying any more than the minimum amount back each month -- until you hit it. It’s also worth noting that credit cards sometimes feature perks such as cash-back rewards or free rental car insurance.
When to use a line of credit
- If you’re not sure how much you need for a project. Let’s say you plan on doing some home repairs and home improvement projects that you’ll complete in incremental steps. In that case, you may not know the final cost in advance. “A home equity line of credit may work better in certain situations,” says Black. “But if you don’t have sufficient equity in your home or if you don’t want to secure a line of credit with your home, a personal line of credit could be an alternative worth considering.”
- You need quick, flexible access to cash. Personal lines of credit may serve you better than credit cards in situations where you need flexible access to cash, says Black.
When a line of credit might not be a smart idea
- For big-ticket items with a fixed price. A personal line of credit usually isn’t a good fit for large, fixed purchases, explains Black. When you know much you’ll need in advance, there are less expensive financing options. “If you wanted to finance the purchase of a recreational vehicle, for example, a fixed-rate installment loan would probably be the more affordable option,” says Black.
- If you have credit. To land the best rates, you’ll need to have a pretty strong credit score. In turn, personal lines of credit also may not be the best fit if you have bad credit, says Black. “Lenders typically have stricter approval requirements for lines of credit than they do for personal loans,” says Black. So, you could have a tough time qualifying for a personal line of credit if you have credit challenges like low credit scores, no credit, or perhaps a thin credit file.”
- If you need long-term financing. It’s also important to keep in mind that lines of credit tend to come with an expiration date, explains Black. “At some point in the future, you may no longer be able to draw against your credit line,” she says. “If you’re looking for a source of financing that you can keep in reserve for emergency situations, a credit card may be the better choice.”
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