What is a line of credit and how they work

What is a personal line of credit?

A personal line of credit is a form of credit where a borrower has a total amount available and they can pull down as much of the loan as they would like. Over time they can pay off and draw down from the line of credit without having to reapply for the loan. 

While a personal loan is considered a closed line of credit because it provides a lump sum that is then paid back over a determined length of time, a line of credit is an open form of credit because there is a credit limit that the borrower can draw on as they need it. 

What is an example of a personal line of credit?

Suppose a borrower is approved for a line of credit of say $10,000. This means they are approved to borrow as much as $10,000 but that does not mean that they are required to take all $10,000 up front. They can borrow as needs arise. For instance, a person with a line of credit can borrow $500 today which means that they will only be charged interest on that $500 and borrow another $500 in a week. So long as they continue to make their payments they can borrow against their total line amount whenever they want without having to seek approval. 

How does a line of credit work?

A personal line of credit allows you to obtain approval for borrowing up to a certain line amount, but does not require that you take the money immediately, or even all at once. While a line of credit may have fees like annual, maintenance, or advance fees, interest is only charged on the amount currently borrowed, not the total line amount. This can provide flexibility without the risk or cost of taking out a large loan. 

The following is an example of how a line of credit might work in practice based on a line amount of $10,000, a 7% interest rate, and a 2% principal paydown requirement:

How do you pay back a line of credit?

Because a line of credit allows you to borrow repeatedly from the same total line amount, it can be confusing how you are expected to pay it back. Paying back a line of credit isn’t too different from a traditional loan: there is a monthly required payment which includes interest expense for the period and a principal paydown amount. Because of the ability to draw down or pay off the line of credit, the payments for a line of credit will not remain the same from month to month. 

What is the repayment period for the line of credit? What is the term of a line of credit?

Unlike a closed form of credit like a personal loan, a line of credit does not have a fixed term. How long it takes to pay off a line of credit will be dependent on the required principal pay down amount, how much you borrow over time, and your ability to make more than the minimum payments.

Do you pay principal on a line of credit?

A line of credit usually requires that each minimum payment includes more than just the interest owed. This means that making the minimum payment will help you pay off your loan over time. However, the principal pay down percentage is often very low which means that paying off your loan by making only the minimum required payments will take a very long time. 

It is always advisable to make more than the minimum payment.

How does line of credit interest work?

When calculating the interest due on a line of credit, you only calculate the interest due based on the amount of money that has been borrowed, not the total credit available. 

For example, if the line of credit is for $10,000 but the borrower has only drawn down $1,000, the interest will be calculated against the $1,000. Suppose the annual interest is 7% on a line of credit. That means a monthly interest due would be $5.75 (7% ÷ 365 = 0.019%→ this is the daily interest rate. 0.019% × 30 = 0.575% → this is the interest rate for a 30-day period. $1,000 × 0.575% = $5.75 → this is the total interest due for the month.)

What is a principal paydown for a line of credit?

While you can borrow and pay off a line of credit as much as you want, most lenders require that a monthly payment include a principal pay down. A line of credit’s principal pay down is usually calculated as a percentage of the outstanding, or borrowed amount. The line of credit agreement will state the percentage. A principal pay down could be as low as 2%, but some plans could be much higher, like 10%.

What is an example of how you calculate the principal paydown for a line of credit?

Suppose you have been approved for a $10,000 line of credit with a principal pay down of 5%. At the time of your first statement, you have drawn down $1,000. Your principal pay down for your first payment would be $50. Of course, this would not be your total payment as fees and interest would be included. This would be your principal payment. 

How do you calculate the minimum monthly payment on a line of credit? How do payments work on a line of credit?

There are two components to a line of credit’s minimum monthly payment: the interest or fees associated with the outstanding and the principal pay down requirement.

Suppose you had a $10,000 line of credit with a 7% interest rate and a required 2% monthly principal pay down. 

Currently, the outstanding is only $1,000 (which means $9,000 of the credit remains available). The monthly payment would include interest on the $1,000 for the month, which would be $5.75 (see above for the calculation) and 2% of the outstanding, which would be $20. The total payment would be $25.75.

If you did not draw down any additional funds, the next month your principal would be $980 and your total payment would be $25.43 ($19.60 in principal paydown + $5.83 in interest).

As you can see, a line of credit will not have a consistent payment month to month even if you do not borrow more money from the line. The minimum payment for a line of credit is a little bit different than you would find with a personal loan. A personal loan’s monthly payment is fixed and determined at the beginning of the loan while a line of credit is not fixed because it depends on the amount outstanding. 

What is the minimum payment on a line of credit? 

Unlike personal loans, mortgages, and car payments, lines of credit do not have a fixed payment. The payment depends on the outstanding balance. The minimum payment on a line of credit will comprise of interest charged and the required principal pay down percent, both calculated on the outstanding balance. 

Do lines of credit have minimum payments?

Lines of credit do have a minimum payment due each month (or, in some cases, every other week), but the minimum will be variable based on the outstanding amount. The minimum payments will not be calculated off of the total approved line amount, but against the amount that has been pulled from that credit line. 

What are the benefits of a line of credit? 

A line of credit is one of the most flexible forms of credit because it gives you access to a credit line that you can pull from anytime without the need to seek additional approval. The benefits of a line of credit include:

Save on interest: With a line of credit, you are only charged interest on the money you use. You don’t need to borrow any money until you need it. 

Only one application: With a line of credit, you can borrow more than once without needing to re-apply.

Lower your debt level: When you have a line of credit, you can limit how much you borrow. With a traditional loan, you might be tempted to take more money than you need for the present emergency to make sure you don’t run out of money before your next paycheck. With a line of credit, you can take only what you need because you can always get more a week later if you need it. 

Safety net: A line of credit is a safety net that is there when you need it. You can always be comfortable that you have access to funds.

Aggressive debt payoff: You can be more aggressive in paying down your debt because if something comes up, you can always borrow more. Some people don’t pay off a loan as quickly as they can because they feel like they need to make sure they have some savings in case something comes up. If they put all their free money toward a personal loan, they will not have anything in case an emergency comes up. With a line of credit, you can put any extra money into paying off the loan because you know you have ready access to credit if an emergency comes up. 

Credit score benefits: A line of credit is categorized as a revolving credit line on the credit report. That means that a line of credit is contributing positively to your utilization even when you aren’t using it. Low utilization positively helps your credit score. Paying down your line of credit would also improve your utilization. Another benefit is by making regular, on-time payments you are building a good credit history. 

What are the disadvantages of a line of credit? 

Some of the disadvantages of a line of credit include:

No clear term to pay it off: Lines of credit do not have a clear loan duration. While they do have requirements of principal paydown, often the requirement is very low which means you can be in debt for a very long time if you only pay the minimums. 

Easy access to credit: One of the benefits of a line of credit is having easy access to credit, but that can also be one of the disadvantages. If you are not disciplined, having access to money whenever you need it could cause your debts to balloon. 

Fees: Some lines of credit have an annual fee or maintenance fees even if your balance is zero. In that case, you might be paying for it even if you don’t need it. 

Credit score downsides: If you need to use a significant percentage of the line of credit, it could drive up your revolving credit utilization. A high revolving credit utilization is not good for your credit score. 

Harder to plan payments: The payments on a line of credit change month-to-month which can make it hard to plan for those payments in your budget. 

What is the risk of a line of credit?

The risk of a line of credit is similar to the risk of any form of debt. If you over-extend yourself and struggle to make your payments, it could cause financial stress. The fact that a line of credit’s monthly payments will be different every month, it could be harder to plan for the payments. The changing payment size could disrupt some of your careful financial planning.

How do you get a line of credit? How do you qualify for a line of credit? 

You apply for a line of credit in the same way you would apply for any form of credit. The application includes your credit report, proof of income, proof of identity, and a bank account in good standing. Aside from being approved for the credit, one of the biggest challenges of getting a line of credit is finding a financial institution that offers them. Many banks, credit unions, and non-bank lenders do not offer lines of credit, although they are becoming more popular in recent years. 

Who should use a line of credit? What do people use a line of credit for?

The following are good examples of people who can benefit from a line of credit:

• People who repeatedly borrow money
• People who have uneven incomes
• Small business owners who need to make uneven purchases
• People who take out personal loans more than once a year
• People who are funding long-term projects that have costs that come over time

When should I use a line of credit? In what situations should I consider a line of credit?

The following are good examples of when it would be good to have a line of credit:

• When you are funding a project that have costs that will spread out over time
• When your income comes in uneven batches and your expenses are predictable
• When you want to avoid having to apply for loans repeatedly

What is a home equity line of credit or HELOC?

Home equity line of credit or HELOC is a line of credit secured by the title to your home. The purpose of a HELOC is often to do repairs or upgrades to a person’s home, but the money can be used for other purposes as well.

Personal line of credit vs. Business line of credit vs. home equity line of credit (HELOC)

There are three different types of lines of credit that are often talked about. The first one is a personal line of credit which can be used for any reason. The second one is a small business line of credit which small businesses often hold in order to obtain the working capital needed to maintain a business. The final type of line of credit is a home equity line of credit or a HELOC which is secured by a person’s home.

What is the difference between a line of credit and a credit line?

A line of credit is an open revolving form of credit which is a type of credit line. However a credit line is a broader term for any type of loan that is often represented on a person’s credit report.

What is the difference between a line of credit and a credit card?

A line of credit could be described as the cross between a personal loan and a credit card. It is like a personal loan in that it is a form of credit where money exchanges hands that can be used for any reason. But it’s like a credit card in that it is an open line that can be drawn down and paid off and drawn down and paid off.

What is the difference between a line of credit and a loan?

The difference between a personal loan and a line of credit is that a line of credit is an open revolving form of credit. While a personal loan has a lump sum with set payments and a set term to the loan a line of credit is an open line that can be used in increments and remains open until it is formally closed.

Personal loan vs. Line of credit

How does a line of credit affect my credit score?

There are a couple of ways that a line of credit can affect your credit score. The first is the same way any form of credit would affect your credit score when you make on time regular payments. Payment history is one of the most important components to a credit score, so line of credit can provide a long-term history of on-time payments. Unlike a personal loan where the payments stop when the loan is paid off, a line of credit can remain on a person’s credit report even when it’s paid off and then can be used again in the future. 

The second way a line of credit affects one’s credit score is through utilization. Utilization is the percentage of a person’s approved line amount that they are currently using. Because a line of credit is a revolving form of credit it is part of the utilization calculation. For example, if you had a line of credit and had taken $1,000 out but your total line amount was $10,000 your utilization would be 10%. The lower one’s utilization is the better it is for their credit score.

What are the fees associated with a line of credit? 

Not all lines of credit have the same fees and fee structure. However some of the fees associated with lines of credit included:

Interest: most lines of credit charge interest based on the amount outstanding. The interest is stated as a yearly interest rate but it is calculated daily.

Carried balance fee: some lines of credit do not actually charge an interest rate but charge a carried balance fee. That means at a certain date a fee is charged based on the outstanding amount. In this case the fee would not be charged on a daily basis.

Application fee: lines of credit May charge an application fee when setting up the account.

Transaction or cash advance fee: a line of credit may charge a cash advance fee which would be a small percentage of the amount when it is pulled out. A carried balance fee or interest would then be charged going forward on the outstanding balance.

Late fee: it is not uncommon for financial institutions to charge a late fee when a borrower does not pay the full minimum payment due by the due date.

Annual fee or maintenance fee: some lines of credit charge an annual fee or a maintenance fee to keep the account open.

There are other costs that might be incurred when obtaining a home equity line of credit. Because a HELOC is secured by a person’s home, lenders may require a title search, mortgage preparation and filing, and taxes. 

Is a line of credit secured? 

A line of credit can be secured by an asset or unsecured. A secured line of credit means that if a person defaults on the credit they asset can be reclaimed by the lender to offset the loss of the loan. The most common form of secured line of credit is a home equity line of credit or a HELOC loan.

What does LOC stand for?

LOC is a common acronym for line of credit, a form of credit where a lender approves a borrower for a total line amount that the person can borrow against repeatedly.