What is a line of credit (LOC)?
A line of credit (LOC) is a fixed amount of money that can be borrowed whenever needed. Until the limit is reached, the borrower can withdraw funds as needed. In the event of an open line of credit, funds can be borrowed again as they are paid back.
A letter of credit (LOC) is an agreement that sets the maximum loan amount a customer can take from a financial institution, usually a bank. As long as the borrower stays within the maximum amount (or credit limit) specified in the agreement, they can access funds from the LOC whenever they want.
Knowing About Credit Lines
Every LOC has a fixed amount of money that can be borrowed, repaid, and borrowed again as needed. The lender sets the interest rate, payment schedule, and other guidelines. Certain LOCs come with a credit or debit card, while others only let you write checks (drafts). There are two types of lines of credit: secured (backed by collateral) and unsecured (usually with higher interest rates). The primary benefit of the LOC is its inherent flexibility. Borrowers are only required to use part of the amount they seek. Instead, customers can adjust their LOC expenditure to suit their requirements and only pay interest on the amount they withdraw—not the whole credit line. Furthermore, borrowers can modify their repayment amounts based on cash flow or budget. For instance, they can repay the amount owed or the required minimum each month.
LOCs: Unsecured Versus Secured
LOCs are often unsecured loans. This indicates that the borrower has not pledged any collateral to support the LOC to the lender. A home equity line of credit (HELOC), backed by the equity in the borrower’s house, is one prominent exception. Because they offer a means of recovering the advanced cash in the case of nonpayment, secured LOCs are appealing to lenders.
Because secured LOCs sometimes have a higher maximum credit limit and substantially lower interest rates than unsecured LOCs, they appeal to consumers and company owners. Additionally, obtaining an unsecured loan is more challenging and frequently requires a higher credit score or rating. By restricting the amount that can be borrowed and raising interest rates, lenders try to offset the increased risk. The high annual percentage rate (APR) on credit cards is partly due to this.
The credit limit, or the maximum amount you can charge on a credit card, represents the card’s parameters. In technical terms, credit cards are unsecured LOCs. However, you do not pledge assets when you open a credit card account. The credit card company can accept nothing as compensation if you begin to miss payments.
Lines of Credit: Revolving versus Non-Revolving
Many people classify a line of credit (LOC) as a revolving account, sometimes an open-end credit account. Through this arrangement, borrowers can spend money, pay it back, and then spend it again in an almost endless cycle. Installment loans, like mortgages and auto loans, are distinct from revolving accounts, like credit cards and LOCs.
Installment loans require borrowers to borrow a certain amount of money and return it over time in equal monthly payments. Customers can only use the money from an installment loan again if they apply for another one.
The characteristics of revolving credit (or a revolving LOC) are also present in non-revolving LOCs. There is a predetermined credit limit, money can be used for many different things, regular interest rates apply, and payments can be made anytime. One significant exception exists: the available credit does not reload when payments are made. When the LOC is fully paid off, the account is closed and cannot be opened again.
For instance, banks occasionally provide personal LOCs under the guise of an overdraft protection scheme. A banking customer can enroll in an overdraft plan tied to a checking account. The overdraft protects the consumer from having a check bounce or having a purchase rejected if they exceed the amount available in the checking. An overdraft has to be repaid with interest, just like any other LOC.
Different Types of Lines of Credit:
There are several different types of LOCs, and they may all be classified as either secured or unsecured. Beyond that, every kind of LOC has unique qualities.
Credit Line for Individuals
This gives one access to unsecured money available for borrowing, paying back, and borrowing again. A credit score of 670 or above, consistent income, and no past defaults are typically prerequisites for opening a personal loan. While collateral is not necessary for a personal LOC, having funds and collateral in the form of stocks or certificates of deposit (CDs) both help. Personal loans are used for travel and entertainment, crises, weddings and other special occasions, overdraft protection, and to help people with variable incomes get through rough patches.
Line of Credit for Home Equity (HELOC)
The most popular kind of secured LOC is a HELOC. The house’s market value, less the amount owed, secures a HELOC and serves as the foundation for calculating the loan amount. Usually, the credit limit is equivalent to 75% or 80% of the home’s market value, less the remaining mortgage balance.
A draw period, often ten years, is a feature of HELOCs that allows the borrower to access available funds, repay them, and take out new loans. The remaining amount is either payable after the draw period or a loan is extended to pay it off gradually.
Closing fees for 3 HLOCs usually include the price of an appraisal for the collateral property.
Credit Line for Businesses
Businesses use these instead of getting a fixed loan to borrow money as needed. Based on an assessment of the business’s market worth, profitability, and level of risk, the financial institution issuing the line of credit. Depending on the extent of the requested LOC and the examination findings, the LOC may be secured or unsecured. Variable interest rates are a feature shared by nearly all LOCs.
Credit Line on Demand
Although it is rarely used, it can be secured or unsecured. The lender may call the amount borrowed due when there is a demand loan. Depending on the terms of the LOC, repayment options include interest only or interest + principle (until the loan is called in). Spending by the borrower is always permitted up to the credit limit.
Line of Credit Backed by Securities (SBLOC)
This is a unique secured-demand loan where the borrower’s shares are security. An SBLOC typically allows the investor to borrow between 50% and 95% of the account’s asset value. SBLOCs are non-purpose loans, which means the borrower is not permitted to trade or purchase securities with the proceeds. Almost every other kind of spending is acceptable.
SBLOCs have monthly interest-only payments to the borrower until the loan is paid off in full or the bank or brokerage requests payment. This may occur if the investor’s portfolio value drops below the LOC’s maximum amount.
Restrictions on Credit Lines
The flexibility to borrow only what is required and avoid paying interest on a large loan is the primary benefit of a letter of credit (LOC). However, before taking out an LOC, borrowers should be aware of potential issues.
- Compared to LOCs secured by collateral, unsecured LOCs feature higher interest rates and credit requirements.
- LOC interest rates are nearly always variable and differ significantly among lenders.
- Compared to credit cards, LOCs do not offer the same regulatory protection. There may be harsh consequences for missing payments and exceeding the LOC limit.
- An open line of credit may encourage excessive spending, making payments impossible.
- When a loan is misused, it can lower a borrower’s credit rating. The services of a reputable credit repair company may be worthwhile, depending on the severity.
Which kinds of lines of credit (LOCs) are most common?
Home equity (HELOCs), business, and personal lines of credit (LOCs) are the most prevalent kinds. Business LOCs can be secured or unsecured, although personal LOCs are usually unsecured. The market value of your house serves as security and backing for HELOCs.
How is a LOC used?
An LOC is helpful for a variety of things. Examples are paying for a wedding, a trip, or an unforeseen financial emergency.
What is the impact of a LOC on my credit score?
Lenders run a credit check when you apply for a line of credit. This temporarily reduces your credit score by creating a hard inquiry on your credit report. Your credit score will also suffer if you use over thirty percent of the available credit limit.
Conclusion
- A line of credit (LOC) is a predetermined borrowing limit that a borrower can access whenever the line of credit is open.
- Personal, business, and home equity credit lines are examples of credit lines.
- The main advantage of a LOC is its inherent flexibility.
- High-interest rates, late payment penalties, and the possibility of overspending are all potential drawbacks.
