A line of credit is a predetermined amount of money lent by a bank or other financial institution. A customer can take funds out, up to the agreed upon maximum amount, and will pay interest on any funds withdrawn.
What Is a Line of Credit?
A line of credit (abbreviated as LOC) works as a pool of credit. That amount is capped by the credit limit. Lines of credit are flexible — you can spend the entire sum at once or only take portions. This can be done an unlimited number of times during the draw period (which can last up to a few years). ¹
LOCs can come in several forms. Credit cards are one example of a revolving line of credit. Overdraft protection pulls funds from your LOC to complete transactions or prevent checks from bouncing when you have insufficient funds.
Your creditworthiness will be an important factor in your LOC pool limit. A better credit score will mean a higher maximum amount of credit. However, a solid rating will also give you lower LOC interest rates.
Do You Pay Interest On a Line of Credit?
Just like any other loan, lines of credit are subject to interest. But, with LOCs interest applies to borrowed sums, not the entire credit pool. You will only pay interest fees on the withdrawn amount.
Lines of credit can be secured and unsecured. Secured LOCs are backed by collateral.² The creditors face less risk when issuing such lines of credit. That’s why you’ll also pay lower interest with a secured LOC. A typical example is a Home equity line of credit (called HELOC), but the most common unsecured LOC product is a credit card.
It is easier to apply for secured lines of credit because of the collateral. To get an unbacked LOC, you’ll want to make sure you have a good credit rating. This will also get you lower fees, as an unsecured line of credit can be expensive. Lines of credit without backing may have a higher APR.
Some financial institutions or credit card companies charge fees other than interest, such as a monthly account maintenance fee, called the unused line fee. By having an account with CreditNinja, you’ll always know which fees you need to pay and why. No unpleasant surprises!
What Is a Revolving Line of Credit?
Some lines of credit allow the customer to fill the pool of drawable cash back up by repaying used credit. These are called revolving LOCs. Withdrawing $2,300 from your $3,000 LOC will leave you with just $700 of available credit. However, by repaying the borrowed sum of $2,300 plus interest, you will replenish the pool back to $3,000. Overdraft protection can work this way, providing you with immediate access to an unconditional revolving line of credit (which is, appropriately called an “overdraft line of credit”.)
Non-revolving lines of credit don’t have this function. Once you’ve used up a portion of the money, it’s gone for good. Repaying the $2,300, with all expenses, won’t replenish the usable cash — you’ll have $700 left on your line of credit. And once the whole amount is used, the account is closed.
How Can I Repay My Line of Credit Fees?
Most banks or credit issuers will give you a choice on how to repay used credit. Interest only applies to withdrawn sums. With CreditNinja, you can choose which repayment plan works best for you. You can opt to pay only the minimum installments. Stick with whichever plan works best for your personal finances.
Are Lines of Credit Better Than Personal Loans?
LOCs have important advantages over typical loans. By taking a personal loan, you’ll receive the whole principal at once, and interest will accrue on the entire sum. This can prove costly if you don’t need the entire principal. Lines of credit allow you to choose how much you want to borrow, and when you want to do it. Interest will apply only to withdrawn amounts. This way, you can save money in the long run.
In addition, revolving LOCs let you redraw cash as much as you like. With personal loans, once the money is used, there’s no way to replenish it.
Why Are Most Personal Lines of Credit Not Secured?
When it comes to finding the right loan or line of credit, one of the main factors to consider is whether to go with a secured or unsecured option. But what is the difference, and what are the pros and cons of each?
When it comes to lines of credit, many of them are unsecured. A home equity line of credit is one of the secured options you may come across. But your standard line of credit is usually unsecured.³
A secured loan or line of credit is one that requires collateral. And collateral is a valuable item or asset that you offer the lender in exchange for the loan. Once you pay back the loan or line of credit you get your collateral back. But if you can’t, or don’t, repay the loan, the lender can keep you line of credit to cover their loss.
Collateral offers a layer of security for the lender. If they have collateral from the borrower, they know they won’t lose all of the money they’ve lent because they can sell the collateral to recover their loss. Unsecured loans on the other hand don’t offer as much security to the lender. And less security can mean higher interest rates.
Secured vs. Unsecured Lines of Credit: How Are the Interest Rates Different?
Unsecured loans tend to carry higher interest rates than secured loans, depending on the type of loan in question. Since the lender is taking a larger risk with an unsecured loan, they may charge more. So. if you’re willing to offer up collateral for your loan or line of credit, it could potentially get you a better interest rate.
You might also find secured loans to be less strict with the approval process. This is because the lender already has an added layer of security with your collateral. Unsecured loans usually require the lender to vet their customers more thoroughly. This is to ensure that anyone they give a loan to is able to repay it in the long run.
- Line of Credit | Investopedia
- Difference Between Secured Line of Credit & Unsecured Line of Credit | Investopedia
- How Does an Unsecured LOC Work? | The Balance