People don’t typically consider a line of credit when they need money. Going to the bank to get a conventional variable- or fixed-rate loan or even obtaining a credit card are typically the first things that come to mind.
For those tight-on-cash scenarios, you might also think about borrowing from relatives or friends, using specialist peer-to-peer or social lending websites, or visiting payday lenders and pawnshops.
However, if you want quick access to money, a revolving line of credit may be the best option. But how does a credit line really work?
Credit lines are often used by businesses to fund working capital or investments, but they’re not as popular with individuals, as banks don’t typically offer them as much as they do loans or credit cards.
A home equity line or HELOC is often the only credit type that is available, however, as it requires your home as collateral, it always comes with risks.
Let’s dive a little deeper into how a revolving line of credit works.
What Is a Line of Credit?
A line of credit is a flexible loan that you can get from a bank or other lender.
A line of credit is in many ways similar to a credit card, as it provides you with a credit limit that you can use. You can also make repayments when you want.
Similar to a loan or credit card, with a line of credit you’ll be charged interest from the moment you borrow money from your available credit.
Borrowers must be approved by the bank or lender, which is typically determined by the borrower’s credit rating or existing relationship with them.
Although lines of credit are less risky than credit cards and loans, they may still cause issues for banks and other institutions when looking at their earning assets as they can’t manage the outstanding balances of credit lines.
A line of credit has its benefits, as borrowers who need credit continuously can’t take out a loan each month and repay it, then take out another loan.
So both of these issues are solved with credit lines, which make a set amount of money available to borrowers when they need it.
What Is a Revolving Line of Credit?
With a revolving credit line, you are given a specified credit limit. This limit is determined by your income, credit history, and credit score.
When the account is opened, the borrower is free to use it in any way they see fit and it remains open until it is closed by either the lender or the borrower.
The money on the revolving credit account becomes available for borrowing once the payments have been made on it. As long as you don’t go over the credit limit, you can use the credit over again.
Revolving credit is commonly used by companies and small business owners to finance capital investments or as a safety net against potential cash flow issues.
People can use revolving credit for large purchases as well as continuous costs like home renovations.
The lender may agree to raise your credit limit if you maintain consistent, timely payments on a revolving credit account.
Revolving credit accounts do not have a fixed monthly payment, but interest still accrues as it would for any other type of credit. Borrowers only have to pay interest on the money they actually withdraw from the credit line.
Revolving Credit vs. Line of Credit
Examples of Revolving Credit Lines
One of the most common forms of revolving credit is a credit card. You get a credit limit and you can spend up to that maximum.
You can make payments to your credit card and then reuse that amount as the credit becomes available to you again.
Another example of a revolving line of credit is a home equity line of credit (HELOC). YOu are given a credit limit based on the value of your home and you can access the funds with a credit card or check connected to the account.
Examples of Non-Revolving Credit Lines
An example of a non-revolving line of credit is an overdraft protection plan. You can link an overdraft plan to your check account and if your balance goes below zero, the overdraft will keep your account from bouncing a check, for example.
Benefits of Credit Lines
Lines of credit are not ideal for larger purchases like houses or cars. For these big items, consider taking out a personal loan rather than a line of credit.
Always manage your revolving credit facility properly, it can be a risky way to borrow. Remember to keep your credit utilization rate below 30% to avoid a negative impact on your credit score.
Similar to a business credit line, a personal line of credit is used to finance random purchases and assist with monthly expenses.
For a self-employed person or those whose monthly income varies, a credit card could be a good way to solve cash flow issues.
A line of credit, on the other hand, is ideal as it typically has lower interest rates than a credit card and offers more flexible payback terms. For instances where there are frequent expenses, lines of credit are helpful.
Lines of credit were widely used to finance home renovations or improvement projects during the housing bubble. And although buying a house requires a mortgage, any repairs or home improvements can be paid for by a line of credit.
Personal lines of credit are additionally given in overdraft protection programs provided by banks. While not all overdraft plans are covered by personal lines of credit and banks may not be eager to offer them, many of them are.
Another example of how a credit line can be used quickly and as needed is to pay for unexpected emergency expenses.
Drawbacks of Credit Lines
Like any financial product, lines of credit can also have some drawbacks.
To repay the account, some borrowers may draw on their credit line, which can quickly become very expensive. However, make sure you are familiar with the terms of your credit line, especially for repayments.
Credit checks are necessary when applying for a line of credit, and applicants with bad credit can find it difficult to be approved.
Since unsecured credit lines are credit lines that are not backed by your assets, your credit profile is taken into account when you apply.
Lines of credit are not always the best option to borrow a large sum of money. If you plan on making a once-off purchase, consider taking out a personal loan or a loan that is meant for something specific like a car or a house.
A revolving line of credit is typically less expensive than a credit card but more expensive than a payday loan; however, it can be more expensive to maintain compared to a traditional secured loan like an auto loan or mortgage.
The interest paid on a credit line is usually not subject to tax. However, if you don’t use your credit line, some banks may charge monthly maintenance fees.
Also remember that as soon as you start drawing from your credit line, you need to pay interest. This may end up being more expensive as you can easily keep on drawing and repaying without a fixed schedule.
Comparison of Lines of Credit with Other Types of Borrowing
While there are many similarities when you look at lines of credit and other forms of credit, there are also important differences between them.
Line of Credit vs Credit Card
Credit cards are similar to lines of credit in that they both have an available credit limit set to the account.
With both of these credit types, you can only borrow up to this credit limit and lenders may have different rules when it comes to exceeding this limit.
Banks are usually not very keen on extending an overdraft. They will more likely just extend the credit limit if you qualify.
If your revolving line of credit is approved, similar to a credit card, you can start accessing your credit immediately and use the funds at your discretion.
Finally, both credit cards and credit lines may charge an annual fee, however, interest is not charged unless you have an outstanding balance.
You can use real estate as collateral to secure a line of credit, which you typically can’t do with secured credit cards.
Also, HELOCs may be harder to get approved for, but they still offer lower interest rates than personal revolving lines of credit. Lenders will also increase their interest rates if you don’t make your minimum payments.
Line of Credit vs Personal Loan
A line of credit is in many ways similar to a traditional loan. You need to be approved for credit and you’ll pay interest on money borrowed.
Similar to a personal loan a credit line can be used to improve your credit score.
However, a revolving line of credit is more flexible than a personal loan.
This is because you can borrow as needed and make payments that will increase the available pool of credit again.
However, although you can use your credit line for a fixed amount with pre-arranged repayments, it will incur higher interest rates.
Getting access to quick cash can be difficult if you don’t have good credit. But there are still many options for loans even if you have poor credit.
💡 Read more: 8 Ways to Find Cash Fast
Payday and Pawn Loans
However, this type of borrowing comes with very high interest rates and fees.
Pawnbrokers and payday lenders don’t care what you use the funds for, as long as you repay your loan on time and in full.
Now, let’s look at the differences between these credit types.
The cost of borrowing money with a revolving line of credit is much lower than that of a payday loan or a pawnshop loan.
The approval process for a payday or pawn loan is much less complicated and in some cases, you may get a loan without a credit check. Once approved, you will also get your money faster – often on the same day.
Also, banks don’t typically offer small loan amounts or credit lines, which pawnshop loans or payday loans do. Payday lenders, on the other hand, can’t offer the higher credit limits that banks and other lenders do.
The Bottom Line
Credit lines are just like any other financial product. They have their benefits and their drawbacks. It all depends on how you use your credit line – overuse can lead to financial issues and debt – just like credit card overspending.
However, lines of credit can be a cost-effective way of paying for unexpected expenses or having some extra cash when you have cash flow issues.
Always carefully review the terms when applying for a revolving line of credit, and never spend what you cannot comfortably afford to repay.