Having access to credit is like having an outstretched arm – it can give you immediate access to an expensive item that is beyond your current financial reach. It can also be useful for paying off high interest debt, paying a medical bill, or sprucing up your home.
The average credit score of U.S. consumers hit a record high of 710 in 2020, according to Experience data. With this in mind, a large portion of the population qualifies for a personal line of credit. If you have a good credit rating and are considering using a line of credit, there are a few key things to know. Read on to learn everything you need to know about a personal line of credit.
What is a line of credit and how does it work?
A personal line of credit is a type of revolving loan. In other words, you have a credit limit that you can draw from. You can borrow up to that amount and continue to withdraw, as long as you pay back what you borrow. While personal lines of credit offer some flexibility, there are some guidelines:
- Loan amounts. The maximum amount offered depends on the lender, but LOCs typically range between $ 1,000 and $ 100,000. Your maximum as well as your terms and rates depend on a handful of factors, such as your creditworthiness and risk profile.
- Draw period. Unlike credit cards, personal lines of credit have a defined withdrawal period. This is a fixed time frame within which you can borrow money on your loan. Interest starts accruing as soon as you withdraw money from your personal line of credit.
- Repayment period. This is when the refund is due. Once the repayment period begins, you will not be able to withdraw any money until you have repaid what you owe. In some cases, a personal letter of credit may require a lump sum payment at the end of the drawdown period, which requires repayment of the full amount borrowed at one time.
Personal lines of credit versus personal loans
Although they look alike and share some similarities, a personal loan is a lump sum that you receive up front. While a personal line of credit is a type of revolving loan, a personal loan is a type of installment loan. This means that you are making payments over time. Like a personal line of credit, personal loans bear interest.
Secured or unsecured lines of credit
Usually, a personal line of credit is unsecured. This means that it is not backed by collateral such as a car or a house. A secured line of credit is backed by a guarantee.
The obvious advantage of an unsecured line of credit is that you don’t have to offer – and risk losing – a major asset to get the loan. However, as they are considered to be riskier than secured loans, the interest rates tend to be higher and the credit score requirements tend to be higher.
Secured lines of credit tend to have lower interest rates and are easier to obtain. You usually don’t need a credit score as high as unsecured lines of credit. The biggest downside is that you will first need to have an asset that you can offer as collateral and you will need to be comfortable with that arrangement.
Benefits of personal lines of credit
- Useful if you have upcoming expenses but don’t know the exact amounts. One of the best features of a personal line of credit is its flexibility, says Michelle Lambright Black, credit expert and founder of CreditWriter.com. âThis comes in handy when you don’t know exactly how much money to borrow for a project,â says Black. “For example, with home repair and renovation projects that you will be doing in incremental stages, you might not know the final cost up front.”
- Possibility to withdraw only what you need. Another major advantage of a personal line of credit is that you can withdraw amounts at a time. âPersonal lines of credit can be more useful to you than credit cards in situations where you need flexible access to cash,â says Black. âWhile a credit card can give you the option of requesting cash advances, the associated fees tend to be quite high. ”
- Quick access to funds. Once approved, some online lenders can provide access to funds in just one business day.
- Lower rates than credit cards. Personal line of credit rates vary, but typically range from 9.30% to 17.55% Variable APR, which is lower than most credit card interest rates. The higher your credit score, the better the rate you will qualify for.
- Potential for overall debt reduction. Because you have the freedom to borrow only what they need, it could lead to less debt in the long run, says Black.
Risks of personal lines of credit
- More difficult to qualify. Personal lines of credit can be more difficult to obtain than secured loans.
- Higher rates than other lines of credit. Unsecured personal lines of credit tend to have higher interest rates than many fixed rate loans and secured lines of credit.
- The interest you pay is not tax deductible. The interest you pay on a personal line of credit is not tax deductible. However, the interest you pay on a Home Equity Line of Credit (HELOC) is tax deductible, as long as the loan money is used to buy, build or improve a house.
- Variable interest rates. Like credit cards, personal lines of credit have variable interest rates, which are tied to the prime rate. This means that the interest you pay can fluctuate.
What is the difference between lines of credit and credit cards?
Both are revolving loans: you have a credit limit and you pay back as you go. And they’re not both secure. The main difference is that a line of credit usually has a lower interest rate than a line of credit. as well as an initial draw and a repayment period. Once this repayment period has started, you will no longer be able to draw on your LDC. A credit card will have a maximum spending limit, but you can keep spending – without paying more than the minimum amount each month – until you hit it. It should also be noted that sometimes credit cards have like cash back or free rental car insurance.
When to use a line of credit
- If you are not sure how much money you need for a project. Let’s say you plan to do some home improvement repairs and projects that you will complete in incremental stages. In this case, you might not know the final cost in advance. âA Home Equity Line of Credit (HELOC) may work better in certain situations,â says Black. “But if you don’t have enough equity in your home or don’t want to secure a line of credit with your home, a personal line of credit might be an alternative to consider.”
- You need fast and flexible access to cash. Personal lines of credit may be more useful to you than credit cards in situations where you need flexible access to cash, says Black.
When a line of credit might not be a good idea
- For big ticket items with a fixed price. A personal line of credit is generally not suitable for large fixed purchases, says Black. When you know in advance what you’ll need, there are cheaper financing options. âIf you wanted to finance the purchase of a recreational vehicle, for example, a fixed rate installment loan would probably be the most affordable option,â says Black.
- If you have credit. To get the best rates, you will need to have a fairly solid credit rating. In turn, personal lines of credit may also not be the best option if you have bad credit, says Black. âLenders generally have more stringent approval requirements for lines of credit than for personal loans,â says Black. So, you might have a hard time qualifying for a personal line of credit if you have credit issues like low credit scores, no credit, or perhaps a poor credit history. ”
- If you need long term financing. It’s also important to keep in mind that lines of credit tend to have an expiration date, says Black. âAt some point in the future, you may not be able to draw on your line of credit,â she says. “If you are looking for a source of funding that you can keep in reserve for emergencies, a credit card may be the best choice.”