Highlights
- A line of credit is an open-ended loan that allows you to borrow money as you need it.
- Credit lines can be secured by valuable collateral (like real estate) or unsecured.
- Common types of credit lines include home equity lines of credit and credit cards.
- Credit line interest rates often vary with benchmark rates, and payments can increase or decrease accordingly.
Your home’s ancient climate control system is living on borrowed time. The problem: It costs north of $10,000 to install the fancy new heat pump system you need. Even with utility rebates and federal tax credits, that’s more than you can pay out of pocket. And the HVAC company’s financing package charges exorbitant interest rates given your credit score.
Fortunately, you have another option: a low-interest home equity line of credit backed by the equity in your home. It’s a far better fit for your budget than a short-term installment loan.
But it’s not all good news. To avoid an unpleasant surprise down the line, you need to understand how lines of credit work, inside and out, before you apply.
What Is a Line of Credit?
A line of credit is a type of open-ended loan that allows you to borrow money as you need it. You can borrow, or draw, from your line during a fixed or indefinite period of time and up to a borrowing limit determined by your lender.
You can draw on your credit line as you need funds and repay what you borrowed as you’re able. However, your total outstanding balance can’t exceed your borrowing limit. Once your balance equals your borrowing limit, you must repay some of the balance before you can borrow any more.
Secured vs. Unsecured Lines of Credit
A credit line can be secured or unsecured. And it’s important to understand the difference, as much of what you read about credit lines only applies to a couple of types — and that’s for good reason.
Secured lines of credit are backed by valuable collateral, which is a fancy term for an asset you can sell for cash. The most common types of credit line collateral are real estate equity (such as a home equity line of credit) and marketable securities, such as stocks.
A secured line of credit’s borrowing limit is closely related to the underlying value of the collateral. Because asset prices can change, you usually can’t borrow against the full collateral value.
For example, home equity lines typically allow you to borrow the difference between 80% or 85% of the property’s appraised value and the remaining balance on any other loans secured by the property, such as a mortgage. Portfolio lines generally allow you to borrow up to 30% of your portfolio’s value.
Because they’re backed by collateral the lender can seize and sell if you stop making payments, secured credit lines have relatively low interest rates. For example, rates on home equity lines are often just a point or two higher than rates on primary mortgages. But it’s very important that you make regular, timely payments, or there’s a real chance the lender seizes the assets pledged as collateral.
Unsecured lines of credit aren’t backed by valuable collateral. You’re still legally obligated to repay what you borrow, but the lender has no right to seize your property if you stop making payments. However, they can report the delinquency to consumer credit bureaus, which can damage your credit and make it more difficult to qualify for new loans or credit lines in the future (among other unwelcome consequences).
Because they’re riskier for lenders, unsecured credit lines typically have higher interest rates than secured credit lines. For example, the average credit card interest rate is around 20%.
However, when we talk about lines of credit, we’re usually referring to home equity lines or personal lines of credit, as credit cards and portfolio lines work differently.
How a Line of Credit Works
When you’re approved for a line of credit, the lender sets your borrowing limit and the rules for drawing on it, including the amount of interest and repayment terms.
Drawing on Your Credit Line
Once your credit line is open, you can draw against it as needed within the boundaries of your agreement. If the credit line has defined draw and repayment periods (periods during which you borrow versus repay the loan), the lender specifies those. A typical draw period lasts five to 10 years, and a typical repayment period another five to 10 years beyond that.
You can generally make draws electronically by transferring funds from your credit line to a linked bank account or, in some cases, using special paper checks issued by the lender. If your lender is a traditional bank, you may be able to visit a branch to pick up a bank check drawn against the credit line. And some lines of credit come with a Visa or Mastercard payment card you can use to make specific purchases in-person and online.
Interest on Draws
In most cases, draws begin to accumulate interest immediately after you make them.
Unless there’s an interest-free grace period between the draw date and the date interest begins to accrue, you can’t avoid paying some interest on your draws. But you can minimize the total cost by paying off the principal balance as quickly as possible.
Credit lines can have fixed or variable interest rates, but most have the latter. For example, most home equity lines have interest rates that fluctuate with benchmarks like the federal funds rate.
Repaying Your Draws
Credit lines are more flexible than traditional loans, but they still hold you accountable for repaying what you borrow.
Unsecured credit lines, like personal lines, typically require minimum monthly payments. That payment is usually very low, like 1% to 2% of the outstanding balance, but it’s high enough that you’ll eventually pay off the balance if you make only the minimum payment without any further draws. You’re free to pay off your entire balance at any time though, and unless the interest rate is very low, you absolutely should pay off your draws as aggressively as possible.
Secured credit lines may or may not have required monthly payments. For example, home equity lines generally require monthly payments, while portfolio lines don’t. During any draw period, the required payment is often just the interest that has accumulated since the last payment.
If your credit line has a draw period, it’s followed by the repayment period. During the repayment period, you can no longer make draws, even if your borrowing limit is higher than the outstanding balance. You have until the end of the repayment period to zero out the line’s balance, typically by making monthly principal and interest payments set by the lender. On a line with a fixed interest rate, these payments are always for the same amount; on a variable-rate line, they can fluctuate with benchmark rates.
Line of Credit vs. Installment Loan
To understand how a line of credit works, it’s helpful to contrast it with an installment loan, the other major type of loan.
Unlike a line of credit, an installment loan gives you an upfront payment for the entire loan amount, known as the principal. It has a fixed term during which you make a set number of payments, similar to a line of credit’s repayment period. The difference is that there’s no draw period and the principal is fixed from day one.
If the loan’s interest rate is fixed, each payment is for the same amount. If the rate is variable, the payment size may vary, but the number and frequency don’t. At the end of the term, the loan balance is zero and the loan is considered repaid.
Applying for a Line of Credit
Applying for a line of credit is usually similar to applying for a small- to medium-size installment loan, like a personal loan or auto loan. The process has some things in common with the mortgage application process but isn’t as intense or drawn-out.
Factors Lenders May Consider
Depending on the lender and the type of credit line, the lender considers factors like:
- Your credit score
- Specific items on your credit report, such as past bankruptcies or loan defaults
- Your debt-to-income ratio, a key indicator of your ability to repay your credit line
- Your employment status
- The value of any underlying collateral
Steps in the Application Process
To apply for a line of credit, you need to:
- Fill out an application (usually online)
- Provide any documents the lender requests, such as recent tax returns or W-2s
- Give the lender permission to pull your credit report and score
- An appraisal to confirm the collateral’s value, if applicable
Not all types of credit lines have strict application and underwriting processes. For example, portfolio lines of credit usually don’t require a credit check or income verification. The most important (and sometimes only) factor the lender considers is the portfolio’s underlying value.
Line of Credit Management & Considerations
It’s nice to have a credit line (or several) at your disposal, but it’s important to use yours wisely. A credit line isn’t a license to spend recklessly.
Responsible Borrowing & Repayment
Credit lines often have generous borrowing limits, especially when secured by real estate or a well-endowed stock portfolio. And most have very low required monthly payments, at least at first. It’s tempting to treat them like ATMs.
That would be a mistake.
You should only draw on your credit line when you absolutely need to. It’s almost always better to pay for stuff in cash. Getting in too deep can have serious consequences. For example, if you borrow too much against your home equity line and stop making payments, the lender may seize your house to cover the debt.
Likewise, always pay more than the minimum required payment. Set and stick to a reasonable monthly payment during the draw period. Make sure it includes a significant amount of the principal. Pick a future date on which you’d like to have a zero balance and divide the number of months between now and then by your current outstanding balance.
Interest Rates & Fees
Secured credit lines almost always have lower interest rates than unsecured lines, so they’re better from a cost perspective. Other factors can affect credit line interest rates:
- Your credit score
- Your debt-to-income ratio
- The amount of equity you’re borrowing against (for example, a credit line with a borrowing limit up to 90% of your home’s value has a higher interest rate than a line capped at 80% of your home’s value)
As with any other loan or financial account, shop around before choosing a particular credit line. Even small variations in interest rates or terms can have big effects on your total borrowing costs. Some credit lines have restrictive features with financial implications that can be unclear if you’re unfamiliar with them, such as a prepayment penalty or balloon payment (a lump-sum payment for the outstanding balance at the end of the repayment term).
Impact on Your Credit Score
Credit lines have positive and negative credit score impacts:
- Negative impacts: Applying for a credit line usually causes your credit score to drop a bit due to the hard pull. It should bounce back within months. Moving forward, maxing out your credit line can increase your credit utilization ratio and hurt your score. Missing or stopping payments has the greatest negative impact of all, so make sure that doesn’t happen.
- Positive impacts: You can all but guarantee your line’s credit impact is more positive than negative by borrowing only what you need (keeping your credit utilization ratio low) and making timely payments. Responsible use also reduces the risk of your line impacting your ability to repay other loans on your books.
Pros & Cons of a Line of Credit
Credit lines are more flexible and often more budget-friendly than installment loans. However, they have some important drawbacks that may not be apparent at first.
- Allows you to borrow only what you need
- Relatively easy to fit into your budget
- Can have low interest rates
- Can have higher borrowing limits
- May encourage overspending
- Payments can spike later on
- Can result in asset loss
- Interest rates often fluctuate
Pros
Credit lines maximize your borrowing power and can (but don’t have to) minimize your repayments, at least early on.
- You can borrow as needed (and control your interest payments). You can borrow as much or as little as needed as long as you stay within your approved borrowing limit. That’s more flexible and potentially more cost-effective than an installment loan.
- Repayments are relatively easy to fit into your budget. Most lines of credit have low minimum repayments that are easy to fit into your monthly budget. Even if you pay more than the minimum, you can keep your payments low by borrowing only what you need.
- Potential for lower interest rates. Secured credit lines have low interest rates, not far above primary mortgage rates. They’re much more affordable than credit cards and unsecured personal loans.
- Potential for higher borrowing limits. Credit lines usually come with higher borrowing limits than unsecured loans, especially if they’re secured by a valuable asset like a house.
Cons
Credit lines may tempt you to overspend, hurting your budget and credit score. They can also cost more than expected as time wears on.
- May tempt you to borrow too much. The flip side of a generous borrowing limit is the temptation to max it out. That can negatively impact your budget and ding your credit score.
- Payments can increase dramatically during the repayment period. Credit lines’ draw periods are sometimes called “teaser periods” due to their low required monthly payments. The switch flips during the repayment period, when the monthly payment is often several times higher.
- Can result in asset loss. If you use your credit line responsibly and make timely payments, you have nothing to worry about. But you could lose your house if you default on a home equity line.
- Interest rates can rise over time. Most credit lines have variable interest rates. When benchmark rates increase, so do these variable rates. That can increase your total borrowing costs over time.
Do You Need a Line of Credit?
There are some general use cases in which it makes sense to apply for a line of credit.
- You have open-ended borrowing needs. If you know you need to borrow money but don’t know exactly when or how much, a line of credit is a better fit than an installment loan. With a line of credit, your risk of borrowing too much is lower.
- You want to diversify your credit mix. Your credit mix is an important component of your overall credit score. If you only have installment loans on your credit report, a credit line diversifies your credit mix and may noticeably increase your score.
- You have significant equity in a valuable asset, like your house. Many homeowners open home equity lines without a specific purpose in mind. Because a home equity line costs little or nothing to keep open if you don’t draw on it, it’s a useful backstop for unplanned expenses that you can’t (or would prefer not to) pay out of pocket.
- You want to avoid a lengthy application process. Certain types of credit lines have relatively fast, easy application processes. If you have good credit and solid income, you can typically apply and get approved for a new credit card in minutes. Qualifying for a portfolio line of credit is even easier.
Line of Credit FAQs
Before you apply for a new line of credit, make sure you understand what you’re getting into. These are some of the most common questions first-time applicants have.
What Can You Use a Line of Credit For?
You can use a credit line for just about any legal purpose. They’re most commonly used for bigger expenses borrowers can’t or don’t want to pay all at once:
- Emergency home repairs, like fixing a major plumbing leak or drainage issue
- Scheduled home improvements, like kitchen remodels and HVAC upgrades
- Major car repairs
- Major discretionary purchases, such as a long-planned vacation or a new boat
You can use a credit line to cover everyday expenses, but that raises the odds you’ll use it to spend beyond your means. It’s best to treat your credit line like your emergency savings account, to be used only in specific circumstances.
What Are the Common Types of Credit Lines?
At the highest level, there are two types of credit lines: secured and unsecured. Secured lines are backed by valuable collateral; unsecured lines aren’t.
The most common types of secured credit lines are:
- Home equity lines
- Portfolio lines
- Certain types of business lines secured by business assets, such as equipment or real estate
- Lines secured by bank accounts, most often CDs
The most common types of unsecured credit lines are:
- Credit cards
- Personal lines of credit
- Business lines not secured by business assets
Should You Get a Credit Card or Secured Line of Credit?
Both have their uses.
If you’re looking to open a line of credit to finance a major expense or create open-ended borrowing power you can tap or repay over time, a secured line is a better option. It’ll have a higher borrowing limit and, crucially, a lower interest rate than a credit card.
If you’re looking for a daily spending aid you can afford to pay off in full each month, a credit card makes more sense. As long as you use it responsibly, it’ll build your credit over time, which could set you up to earn better rates and terms on future loans and credit lines.
But absent a true emergency, you should always pay off your balance in full to minimize your exposure to famously high credit card interest rates.
Final Word
You can use a credit line for basically anything, but you don’t have to.
In a nutshell, that’s why credit lines are so useful. Unlike an installment loan, a credit line doesn’t obligate you to repay a set amount of money over a set period of time. You need to repay whatever you draw against it, and your borrowing costs could end up higher than expected, but you have a lot more discretion upfront.
Then again, discretion can be risky. Plenty of credit line users find out the hard way that the option to borrow is not the same as the ability to repay. Failing to hold up your end of the bargain, especially on a line secured by your home’s equity, can have serious financial and personal consequences.
