When applying for a credit account, there will be several differences between credit products, including whether the account is a line of credit or a standard loan. A line of credit is exactly what it sounds like, a credit account you can borrow from multiple times. A typical line of credit does not replenish, and once you use those funds, you will have to apply for a whole new credit account. However, if your line of credit is revolving, once you reach that credit limit, you can make payments to use that account again.
Understanding the details of a line of credit, the pros and cons, along with the alternative, is an important part of deciding on a credit account. Keep reading for everything you need to know about a line of credit.
More Details on How a Line of Credit Works
As mentioned above, a line of credit is a credit account you can borrow from multiple times. You will get your funds after approval and can spend your money in whatever increments you need. With a non-revolving line of credit, you can use funds until you reach your credit limit. If you need more money, you will have to go through an application process again, even if it is from the same lender. With a revolving line of credit, you can pay off your balance and use the same account again.
The Application Process With a Line of Credit
You can find a line of credit at a financial institution like a bank or credit union. Or you can turn to private lenders in-person or online. Credit unions and banks usually have stricter credit requirements than private lenders, so a private lender is likely your best bet if you have bad credit.
Once you find a lender you want to work with, the first step is going to be to apply for pre-approval to open a credit line. With pre-approval, most lenders will ask about your income, the loan amount you are looking for, and your credit score. If an asset is involved with the line of credit, they may also ask about details on that. If you are pre-approved, you’ll know you have a fair chance of getting final approval as long as you can verify everything. Here are the documents you can use to verify your identity, income, and credit:
- To prove your identity, you can use a government-issued photo ID such as a driver’s license, passport, military ID, or permanent residence card.
- You can use pay stubs, invoices, bank statements, tax returns, or letters of income to prove your income.
- If an asset is involved, you will need documentation on that. For example, if a car is an asset, you will need the car’s title. (Unsecured loans will not have an asset).
- To prove your residence, you can use pieces of mail, bank statements, and a lease or mortgage agreement.
Repayment for a Line of Credit
Repayment for a line of credit will usually be with required monthly payments. The amount due for each repayment period will depend on your interest rate and balance. The higher your balance, the higher the minimum monthly payments will be. With each payment, you will pay interest and the principal amount. You can always pay more than the monthly minimum, but you don’t have to. Most people have automatic payments straight from their checking account, but you can also make manual payments each month. If you want to, you can also make a lump sum payment, just ensure to ask your lender about prepayment penalties.
Secured Lines of Credit and Unsecured Lines of Credit
When you borrow money from an unsecured personal line of credit, an asset will not be involved, while a secured line of credit will have an asset involved. A secured line of credit may mean easier approval if you have bad credit.
How You Can Use the Funds From a Line of Credit
How you can use the funds from a line of credit will depend on the type you are borrowing from. Most options, like a personal line of credit, give you the freedom to use the funds for whatever expenses you need. While something like a student line of credit can only be used for school-related expenses.
Examples of a Line of Credit
Here are some examples of different lines of credit you may see when searching for options:
Personal Lines of Credit
Personal lines of credit are similar to personal loans because they are versatile with spending, loan amounts, and interest rates. This type of line of credit is perfect if you have multiple small expenses or want to have a safety net. There will likely be a handful of unsecured and secured lines of credit you can look into with this type.
Home Equity Lines of Credit
Home equity lines of credit allow homeowners to borrow from the equity in their homes. The funds from the line of credit can be used for all kinds of expenses, but in most cases, homeowners usually use them to pay for renovations or improvements. The draw period for a home equity line of credit can be up to 10 years, giving homeowners a good amount of time to use the funds if needed. With a home equity line of credit, you don’t have to have the best credit history.
Credit cards are a form of revolving credit, which means they can be used multiple times as long as you make payments. One of the perks of a credit card is that you can use it for all kinds of expenses.
Business Lines of Credit
A business line of credit can be borrowed from business owners for all kinds of expenses. Whether a business is just starting out, growing, or simply maintaining things. A credit line can be a great alternative to a loan for business owners because their projected expenses can change quickly.
How Do Lines of Credit Affect Your Credit Scores?
Credit lines can impact your scores in a few different ways. The first way that a line of credit can impact your credit scores is through the application process. Although pre-approval does not affect your credit, the final approval will. There is usually a hard credit check with final approval, which can bring down your credit score by up to five points.
Once you take out the loan, it can impact your credit utilization ratio. Your credit utilization is the amount of debt you have vs. your available credit. Ideally, you want that ratio to stay under 30%. If adding a credit account means that the percentage goes up, then it can negatively impact your credit score.
If adding a loan increases your credit diversity, then it can help your score! How you make your credit line payments will also affect your credit. On-time payments can really help your credit, while any late payments will hurt it.
The Differences Between Standard Loans and a Line of Credit
If you haven’t taken out a standard loan or line of credit before, you may be curious about their differences. With a standard loan, such as a personal loan, you will have to repay your loan in equal monthly installments. Once approved, you will get all the funds in one lump sum, which is the maximum amount of money you will get with it. If you need to borrow more money, you will need to take out a new loan. While with a line of credit, you don’t need to use the entire loan amount upfront. Your monthly payments will depend on how much credit you use, and if the account is revolving, you can repay the loan to use it again.
Advantages and Disadvantages of a Line of Credit vs. A Standard Loan
Here are some of the pros and cons of lines of credit when compared to a standard loan option:
- A line of credit can be a good option when you are unsure about the final cost of a project/expense.
- A revolving line of credit can be a convenient option, as paying it off allows you to use that account again.
- Sometimes, with a line of credit, you won’t have to go through an application process if you need to borrow more funds.
- A standard loan will be more reliable with its monthly payment amount, so it may work better for those on a tight budget.
- A standard loan may be easier to qualify for than a line of credit—more lenders offer bad credit loans vs. credit lines for poor credit borrowers.
- Paying off a revolving account can have a double positive on your credit score; you’ll decrease debt and, at the same time, increase your available balance without having to apply for another credit account.
- Revolving credit accounts like credit cards can quickly lead to a cycle of debt. And so, they may not be the best option for those with bad spending habits.
Consider all of these things, before deciding between a line of credit and a standard loan.