Line of Credit - Explained
What is a Line of Credit?
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Table of ContentsWhat is a Line of Credit?How Does a Line of Credit Work?Secured and Unsecured Lines of CreditRevolving versus Non-revolving Lines of CreditTypes of lines of creditA personal line of credit Home Equity Line of Credit (HELOC) Securities-Backed Line of Credit (SBLOC) Business Line of CreditLimitations of Lines of Credit
What is a Line of Credit?
A line of credit is the amount of money that a bank or a credit institution allows the customer to borrow. The borrower can withdraw the funds from the line of credit as many times as he/she wants. However, there is usually a limit set that the borrower should not exceed. The amount of money the customer borrows has a time limit for repayments and an interest rate relative to the amount. All lines of credit include an amount set for the customer to borrow whenever there is a need, payback, and then borrow again. Some credit lines allow the customer to write checks while others give the customers a credit card to use.
How Does a Line of Credit Work?
When a customer is in urgent need of money, there is the option of applying for a loan or a line of credit. Getting a loan means the customer receives a lump sum, and the interest starts accruing immediately. Whether the client uses the money the same day or one month later, the bank will charge interest from the day the client receives the money. Flexibility is the main advantage that lines of credit offer to clients. A line of credit gives the customer access to some specified amount of money that they can borrow whenever they need it. The customer needs not to use all the money from the line of credit. They can borrow only the little amount they need, pay back with interest then borrow again when there is a need. With credit lines, interest accrues only on the amount the customer draws. Also, the bank allows the customer to adjust their repayment amounts according to their cash flows. A customer can pay the whole amount at once, or make small monthly payments until they settle all the balance.
Secured and Unsecured Lines of Credit
Similar to loans, lines of credit can also be secured or unsecured. Most credit lines are unsecured meaning the lender does not receive any security from the borrower to back the loan. Unsecured credit lines are difficult to obtain, and a borrower needs to have high credit scores. unsecured lines of credit also pose higher interest rates on the amounts the customer borrows. Secured lines of credit attract business owners because the credit limit is always higher with a lower interest rate. The banks and credit institutions also get securities as collateral in case the customer is unable to repay the credit. A bank can also issue a revocable credit line to an individual or a business owner under specific circumstances. The bank has a right to revoke or nullify the source of credit when the financial status of the customer deteriorates. When there is a global credit crisis that affects the markets, the bank can also issue a revocable credit line. The revocable credit line can also be secured or unsecured.
Revolving versus Non-revolving Lines of Credit
A line of credit is a type of revolving account or an open-end credit. The revolving cycles come about when the client borrows money, repays it, and then borrows it again in a never-ending cycle. The money will always be available to the borrower as long as they keep repaying it on time. Non-revolving credit accounts allow customers to borrow money and repay it in installments. These closed-end credit accounts include car loans, mortgages, and signature loans. Once the borrower repays the loan, they cannot spend it again, and they will need to apply for a new loan. Revolving and non-revolving credits share the same features in that there is a borrowing limit, interest rate, and specified time frame for repayment. The major difference is that the pool of money does not replenish in non-revolving credit lines.
Types of lines of credit
Lines of credit come in different types, each being either in the secured or unsecured category. The various types include:
A personal line of credit
A personal credit line offers customer access to unsecured funds. The borrower can have personal savings or stocks as securities, but they are not necessary with this type of credit line. Personal lines of credit are basically for weddings, travel, entertainment, overdraft protection, and other small emergencies. To open a personal line of credit, the borrower needs to have:
- A high credit score
- A reliable source of income
- A credit history with no defaults
Home Equity Line of Credit (HELOC)
Home equity credit lines are secured types of credit. The security is the market value of the mortgage home minus the balance on the mortgage. HELOCs have a draw period of up to 10 years, allowing the borrower access to available funds. The borrower has a revolving cycle on the credit until the date is due. When the date of payment is due, the bank closes the credit line and appraises the home at a cost.
Securities-Backed Line of Credit (SBLOC)
SBLOC is a special type of credit line in which the borrower provides his/her securities as collateral for the credit. The investor can borrow from 50% to 90% of the total value of assets he/she provides. The bank forbids the investor to trade with the securities, but he/she can do any other business with the money. The investor then needs to repay the loan monthly according to the banks interest rates.
Business Line of Credit
Business prefers lines of credit to take one time loans. Lines of credit allows businesses to borrow money only when they are in need. The banks evaluate the profits the business will make, the market value, and the risks of giving credit before allowing the business to open a credit line. Business credit lines can be secured or unsecured depending on the size of the credit the business requests.
Limitations of Lines of Credit
- Unsecured credit lines usually pose higher credit requirements, and interest rates compared to secured credit lines
- Financial institutions and banks have varying interest rates for the lines of credit. The rates could change yearly depending on the terms of the agreement
- Penalties for late credit payments, and drawing past the borrowing limit can be intense
- A creditor can misuse the money that he/she borrows, and this may lead to poor credit scores. Poor credit scores lead to future denial of credit