What is a line of credit?
A line of credit (LOC) is a type of loan that you can get from a bank that allows you to borrow money up to a pre-set limit. You can use as little or as much of the funds as you’d like, up to a pre-specified maximum amount.
What is good about lines of credit, is that you can pay back the money you owe at any time. You only have to pay interest on the money you borrow from the line of credit.
Typically, lines of credit have no annual fees and they allow you to access the funds 24/7 from an ATM or an online transfer.
Types of lines of credit
Here are the 5 different types of lines of credits and pros and cons of each option.
1. Secured line of credit
With a secured line of credit, you use an asset as collateral for the line of credit.
For example, the asset could be your car or your home. If you don't pay back what you owe, the lender can take possession of the asset. The advantage is that you can get a lower interest rate than with an unsecured line of credit.
2. Home equity line of credit
A home equity line of credit is a type of secured credit where your house acts as collateral. This is an option for homeowners who have built up equity in their property.
What is equity?
Equity is the difference between the market value of the home and any liens or mortgages that are currently outstanding on the home.
For example, if a home is worth $350,000 and the homeowner has an outstanding mortgage of $150,000, then there is $200,000 in equity in the home.
3. Unsecured lines of credit
With an unsecured line of credit, the loan isn't secured by any of your assets, so no assets can be seized if there is a default. Examples of unsecured lines of credit include: personal credit cards and student lines of credit.
Unsecured lines of credit often come with higher interest rates as they are seen as high risk for the lender.
4. Personal line of credit
A personal line of credit may be used for unexpected expenses or consolidating higher interest rate loans. These interest rates are usually lower than credit cards and personal loans rates, so be sure to ask your bank or lender.
5. Student line of credit
A student line of credit is specifically for paying for post-secondary education. People typically use student lines of credit to help pay for education expenses, such as tuition, books, and/or housing.
Interest rates on a line of credit
You pay interest on the money you borrow from the day you withdraw money until you pay the balance back in full.
Your credit score may affect the interest rate that you will get with a line of credit. Why? Because it tells the lender how risky you are for them to lend you money.
Usually, the higher your credit score, the lower the interest rate on will be.
Paying back a line of credit
As mentioned lines of credit are open; thus the lender will ensure to send you a statement showing how much you owe each month.
Remember that you must make a minimum payment each month towards this debt. Usually, this payment is equal to the monthly interest, service fees and any other charges.
Keep in mind: If you only pay the interest you'll never pay off the debt that you owe.
Pros and cons of a line of credit
Pros
You'll usually pay a lower interest rate for a line of credit than for a credit card or a personal loan
Usually there is no fee to withdraw funds
You can pay off the debt at anytime
Depending on the lender or financial institution, you may not be charged set-up fees or annual administration fees
To avoid unnecessary fees, secure the line of credit with the same lender or financial institution where you currently bank
Cons
With easy access to money from a line of credit, it can be easy for some to use this as a piggy bank, thus overspend and this can lead to an inability to make payments
Interest rates for LOCs are often variable, so if interest rates increase, you may have difficulty paying back the LOC
There can be severe penalties for late payments and if you go over the limit
Misuse of a line of credit can hurt your credit score.
How a lender determines your LOC limit and interest rate
The lender will take a close look at your finances to make sure you can repay your debt.
Items that will be considered in your LOC application are:
your income
your current level of debt with other financial institutions
your credit report
Line of credit loan insurance
Many financial institutions offer Line of Credit loan insurance., these are also known as:
balance protection insurance
balance insurance
line of credit protection insurance
Please note that you do not need to sign up for insurance to be approved for a LOC. Typically, line of credit protection insurance may help cover your loan payments if you can’t make them due to illness, accident, death or if you lose your job, usually up to a maximum amount.
Please be sure to get all the info about the insurance to determine if the insurance coverage is what you need BEFORE selecting insurance for your line of credit.
The bottom line
Both secured and unsecured lines of credit deliver flexibility and quick access to cash. The ability to have low minimum payments and lower interest rates makes LOCs an interesting method to secure funds for personal and business projects.
If you have to make a choice, the secured line of credit is a very good option as it keeps the costs of borrowing to a minimum.