Line of Credit—Essential Guide to Expectations & Realities

A line of credit is a flexible funding solution that allows you to tap into funds on an as-needed basis. Depending on your situation, a line of credit can offer much-needed access to cash. Lines of credit can be unsecured or secured by an asset, like a home, which can change the nature of the loan.

We will explore what to expect when pursuing a line of credit. With all the information in hand, you can decide whether or not a line of credit is the right financial tool for your situation.

What Is a Line of Credit and How Does It Work?

A line of credit can be a useful financial tool, but to use it effectively, it helps to understand the details of the lending arrangement. Let’s take a closer look below.

Line of Credit Definition

A line of credit is a flexible financial arrangement that allows individuals to borrow money up to a predetermined limit, known as the credit limit.

Unlike traditional loans, a line of credit doesn’t provide a lump sum payment upfront. Instead, borrowers can access funds as needed, making it an adaptable financial tool. This credit arrangement is often open-ended, meaning it doesn’t have a fixed term, and borrowers can draw and repay funds within the agreed-upon limit.

Basic Components of Line of Credit

A clear understanding of the financial terms attached to a line of credit can help you navigate the process more smoothly. Below is a closer look at some of the basic components of a line of credit:

•     Credit limit: The maximum amount a borrower can access, defining the cap on borrowing within the line of credit.
•     Principal: The actual amount borrowed from the line of credit, with interest charged on this balance.
•     Interest rate: The cost of borrowing expressed as a percentage. Rates can be fixed or variable, impacting the overall cost of the credit.
•     Revolving: Unlike traditional loans, a line of credit is open-ended, allowing borrowers to draw, repay, and reuse funds within the predetermined credit limit.
•     Draw period: The specified duration during which the borrower can access funds from the line of credit. It precedes the repayment period.
•     Repayment period: The time frame during which the borrower must repay the outstanding balance. It follows the draw period and may have different terms.
•     Minimum payments: The minimum amount a borrower must pay back each billing cycle, often calculated based on the outstanding balance and interest accrued.
•     Collateral: Depending on the type of line of credit, collateral may be required, such as a home or other assets to secure the credit line.

How a Line of Credit Works

The way a line of credit works is straightforward. Upon approval, the borrower gains access to a set amount of funds, but interest is only charged on the amount that was actually borrowed.

As the borrower repays the borrowed amount, the credit line is replenished, and they can reuse the funds. This revolving nature distinguishes lines of credit from traditional loans. Lines of credit offer greater flexibility for handling unexpected costs or taking advantage of opportunities without the need to obtain a separate loan at every turn.

Interest rates on lines of credit can be variable or fixed, depending on the terms of the agreement. Borrowers have the freedom to use the funds for various purposes, such as home renovations, education expenses, or managing cash flow for small businesses.

How to Get Your Credit Score Ready for a Line of Credit

As with other types of financing, lenders take a look at your credit scores when deciding whether or not to grant you a line of credit.

In general, better credit scores unlock better credit line opportunities. For example, a lender might be more willing to provide a borrower who has good credit with a larger line of credit or a lower interest rate. With this in mind, it’s helpful to have your credit scores in great shape before applying for a line of credit. 

Below is a closer look at some things to keep in mind about your credit score.

What Credit Score Is Needed for a Line of Credit?

Every lender sets different credit score requirements for their lines of credit.

Also, the type of credit line can impact the required credit scores. For example, many home equity lines of credit (HELOCs) are only available to borrowers with at least a 620 credit score. The secured nature of a HELOC means that lenders can be more flexible. But if you are pursuing an unsecured line of credit, you might need to have a credit score of 700 or higher to get approved.

In any case, a higher credit score will always be an advantage when applying for a line of credit.

Is Having a Line of Credit Good for a Credit Score?

Like all types of borrowing, a line of credit can be a good thing or a bad thing for your credit scores. The key is how you manage your line of credit.

For example, borrowers who consistently make on-time payments to their line of credit might see their credit scores grow over time. But if you don’t make on-time payments to your line of credit, your mismanagement of the credit will hurt your credit scores.

Top 5 Tips to Help Qualify for a Line of Credit

If you want to obtain a line of credit, below are some tips to help you get started:

•     Consider secured options: If you have collateral available, a secured line of credit is often easier to obtain than an unsecured line of credit. Depending on the lender, they may accept home equity or cash savings as collateral for your line of credit.
•     Improve your credit scores: Higher credit scores make you much more likely to get approved for a line of credit. Some ways to boost your credit scores include making on-time payments and avoiding high balances on your credit cards.
•     Pay off debt: Paying off debt will lower your debt-to-income ratio, which is a metric most lenders look at when evaluating an application for a line of credit.
•     Compare different lenders: Not every lender is the right fit for you. Do some research ahead of time to find a lender that suits your needs.
•     Watch your income: A stable or rising income is a positive sign for lenders. If you are considering applying for a line of credit, it’s not a good time to take a pay cut.

How to Get a Line of Credit

If you want to get a line of credit, consider taking the following steps:

1. Check your credit scores: Start by reviewing your credit scores. Higher credit scores increase your chances of approval and better terms. If your scores need improvement, consider taking steps to boost them, such as paying down existing debts and addressing any errors on your credit reports.
2. Assess your financial situation: Lenders evaluate your financial stability. Prepare by reviewing your financial situation. Be prepared to share details about your income, assets, and liabilities.
3. Choose the right type of line of credit: Determine the specific type of line of credit that aligns with your needs, whether it’s a personal line of credit, business line of credit, or HELOC. Different types cater to various financial goals and circumstances.
4. Research lenders: Not all lenders are created equal. Research various financial institutions and compare interest rates, fees, and terms. Choose a lender whose offerings align with your financial goals.
5. Submit an application: A compelling application should highlight your financial stability and responsible credit history. After you submit the application, all you can do is wait.

Banks That Offer Lines of Credit

Not every financial institution offers lines of credit, but many do. Some of the banks offering lines of credit in the U.S. include U.S. Bank, PNC Bank, and Capital One.

Line of Credit Pitfalls

Every financial product has pitfalls to be aware of. Below is a closer look at some of the line of credit pitfalls to avoid: 

•     Overborrowing: The flexibility of a line of credit can tempt borrowers to access more funds than they need, leading to increased debt and financial strain.
•     Risk of revolving debt: The revolving nature of a line of credit can result in a never-ending cycle of borrowing and repaying, potentially leading to a perpetual state of debt if not managed carefully.
•     Negative credit score impacts: Continuous use and high balances on a line of credit can negatively affect your credit score, potentially limiting your ability to qualify for other loans or financial products.
•     Secured lines of credit risk property loss: With a home equity line of credit (HELOC), failure to repay could lead to the loss of your home as it serves as collateral. That’s a big risk worth considering.
•     Variable interest rates: Lines of credit often come with variable interest rates, potentially leading to increased costs over time. With varying costs, it can be difficult to fit a line of credit into your budget.

Face Off: Line of Credit vs. Credit Card

Like some lines of credit, credit cards provide unsecured revolving credit with a predetermined limit. They are best suited for smaller, day-to-day expenses, such as groceries, dining, or online purchases. 

In general, credit cards have higher interest rates than lines of credit, making them less cost effective for significant or long-term financing. However, they offer convenience, reward programs, and ongoing, accessible credit for routine expenses.

Since everyone has different financial needs, each of these options could be a good fit for someone. For example, credit cards are often best for individuals with consistent, smaller, everyday expenses and those who prioritize convenience and rewards. In contrast, a line of credit is likely better for homeowners looking to leverage their equity and other borrowers with planned, larger expenses requiring flexibility in repayment.

Face Off: Line of Credit vs. Installment Loan

An installment loan is a more traditional borrowing method. Unlike a line of credit, it provides a lump sum upfront, and borrowers repay the loan in fixed, scheduled installments over a specified period. Installment loans are generally best for one-time expenses with a clear and defined cost, such as purchasing a car or financing a home improvement project.

In general, lines of credit are best for those who require flexibility and anticipate an ongoing need for access to cash. In contrast, installment loans are preferable when a specific amount is needed for a defined purpose, and borrowers prefer the structure of regular, predictable payments. The fixed payment of an installment loan is often easier to fit into a budget.

Expert Tips: How to Make the Most of a Line of Credit

If you obtain a line of credit, it’s time to make the most of the opportunity. Below are some expert tips to consider as you use your line of credit.

Learn From Line of Credit Experts

Here are some ways to make the most of your line of credit:

•     Be responsible: A lender might offer you a higher line of credit. But that doesn’t mean you should max out your line of credit. Only use the funds you actually need.
•     Make on-time payments: As you repay your loan, commit to making your payments on time. Making late payments could hurt your credit score.
•     Watch the interest rate: A variable interest rate means that the interest rate attached to your principal balance can change over time. A higher interest rate means you’ll face higher interest charges. Keep an eye on your interest rate.
•     Repay the loan ASAP: If you take out funds from a line of credit, it’s important to stay on track to repay the debt. If possible, repay the loan ahead of schedule to eliminate this financial burden from your life.

The Best Way to Use Your Line of Credit

The best way to use your line of credit varies based on your financial situation. This flexible funding solution could help you through difficult financial times, but try not to lean on a line of credit for anything unnecessary.

What to Do if You Don’t Qualify for a Line of Credit

If you don’t qualify for a line of credit, consider working on your credit scores. With time and effort, you can significantly improve your credit scores and your chances of landing a line of credit. Take action by paying off high-interest debt and making all bill payments on time.

The Bottom Line

A line of credit might be the right financial tool for your situation. If you want to obtain a line of credit, start by checking out your credit score. Some prospective borrowers might choose to work on their credit score before submitting an application. When you are ready to apply, do your research to find the best lender for your unique situation.