What Is a Line of Credit?

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One of the most frustrating things about personal finance is the sheer volume of vocabulary one has to learn in order to understand their options. As if it wasn’t difficult enough to understand how everything works in the first place, you have to also memorize a multitude of terms and learn how they differ from one another. And just to add a little spice to an already complex recipe, many banks and lenders add their own spin on these terms to make their products seem more compelling. Some basic terms include…

IRA
Roth IRA
Mutual Funds
Index Funds
Money Market
CD
HELOC
Line of Credit

…and the list goes on and on. And these basic terms will look even more obscure once your bank’s marketing department gets a hold of them. Thanks to my early career in banking, I still have these terms rolling around my head when I think about personal finance. The good news is I can now share my knowledge with you! First up: Line of Credit.

What is a Line of Credit

The simple definition of a line of credit is a credit that is offered to borrowers at a specific amount, with the interest only being charged on the amount of money borrowed (not the amount of money offered). A line of credit can take many forms and the amount can be increased or decreased by your bank or lender at their will.

What makes a line of credit unique from loans is flexibility. A borrower is given an amount of credit based on their credit score and the amount is something they can borrow from at any time. Never is a borrower required to use the entire amount of credit extended and the borrower never pays for unused credit.

Types of Lines of Credit

Given this broad definition, it shouldn’t be too surprising that lines of credit can take on many forms. Loosely defined, a line of credit is a type of loan, but sort of opposite to how traditional loans are structured. A fixed loan is an amount of money borrowed at (usually) fixed interest rates and (always) at a fixed amount. A line of credit (often) has variable rates and (always) is based on a credit limit and not an amount of money that must be borrowed at one time. Here are a few various types of forms these lines of credit might take on:

Credit Cards
HELOCs (Home Equity Lines of Credit)
Overdraft Protection Line of Credit
Business Line of Credit
Personal Line of Credit

Credit cards are likely something you already understand well, thanks to their prevalence in today’s society. Credit cards are the lines of credit that give you the easiest day to day spending, since you have card in hand to swipe at any time. Credit cards do not require collateral (an item pledged on the loan that can be taken away in case of default – such as a home or a car) unless you obtain a secured credit card.

HELOCs are a line of credit that use your home as collateral. Collateral is something that secures a loan or line of credit and, if you default on payments, the collateral can be taken away from you. Needless to say, it’s pretty important to stay on top of HELOC payments and the payments of any other secured loans or lines of credit.

Overdraft Protection Line of Credit is a line of credit you can set up in conjunction with your bank account. If your bank account ever goes negative, the negative amount will be charged to your overdraft protection line of credit and a fee charged for each withdrawal (plus interest). The overdraft protection line of credit does not require collateral.

Business Lines of Credit are offered to business owners who have a positive cash flow. This isn’t meant to be used for long-term expenses, but rather for seasonal expenses that can be paid off relatively quickly. Business lines of credit often require collateral.

Personal Lines of Credit are similar to personal credit cards, without having a card in hand to use for expenses. Personal lines of credit do not require collateral and your creditworthiness may depend on your history with your lender in addition to your credit score.

Pros and Cons of Lines of Credit

Lines of credit can be useful tools but, like all other credit tools, should be used with restraint and caution. Here are a few pros and cons to keep in mind:

Pros of Lines of Credit
Lines of credit offer, above all else, flexibility. Rather than putting you into a position of borrowing more than you need, lines of credit offer you the ability to keep a certain amount of credit available to you at all times, just in case. With a line of credit, you’ll never have to borrow more than you need.

Cons of Lines of Credit
Flexibility can be a double-edged sword. In this case, flexibility might make it a little too easy to borrow. Unlike a loan, which is for a specific amount of money and for a specific reason, a line of credit can be used at your desire. And if you don’t keep your desire in check, you could end up deep in debt before you even realize what happened. Usage of a line of credit should always be calculated – freely spending this way always leads to trouble.

Keeping Up on the Terminology

Now that we’ve covered Line of Credit, what other terminology have you found confusing in the past? The importance of understanding these products can’t be underestimated. The more you know, the more empowered you’ll be to make the choices that are right for your financial situation.

Image Credit: Alejandro Escamilla

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