What is a Line of Credit?
July 24, 2020 by Daniel Azzoli
When life throws a curveball, even the most fiscally responsible of us can sometimes find ourselves in need of emergency funds. In these tricky (and often stressful) situations, it may be helpful to have a safety net to ease some of the anxiety and help you take care of an emergency in the short term.
This is where a line of credit may be a lifesaver, especially when you need a leg up to meet your immediate financial needs in the case of an emergency. But what is a line of credit loan, exactly, and which kind is right for you? Let’s walk through some specifics, including the differences between personal lines of credits and traditional installment loans, and how opening a line of credit may be helpful in certain situations.
Lines of Credit Explained
So, what is a line of credit? In short, a line of credit is a type of loan through which you can draw funds on an as-needed basis. You would qualify for a maximum amount of money (similar to a maximum limit on a credit card), after which you would have access to those funds whenever you need them as long as you have available credit.
You wouldn’t be required to actually use the full amount for which you qualify; rather, you would have the option to take as much or as little at any given moment when you find yourself in need.
If you do that, you would only make the payments based on the amount of money you actually draw, along with any applicable interest and/or fees.
You can also draw the maximum amount of your line of credit and as you continue to pay off the balance, you would have the option to draw again from your available credit. If you pay in full, the entire amount of your line of credit would be ready and available for you again. This means you can use and repay your funds repeatedly.
Lines of credit can be “secured” or “unsecured”:
- A secured line of credit requires you to put up collateral in order for the lender to approve your application. If you’re unable to repay the money, the lender can seize your collateral as repayment instead.
- An unsecured line of credit carries no collateral requirements. However, because, this structure may increase the risk of default for the lender, the interest rates on unsecured lines of credit may typically be higher.
Depending on your eligibility profile, the lender you choose, and other qualifying terms, your line of credit may also carry an annual fee. Some lines of credit also carry expiration dates, before which you can use and reuse your credit amount as often as you like. This is typically called the “draw period,” after which you’ll enter the “repayment period,” if you haven’t already paid off your balance prior to your line of credit’s end date. If you need to renew your funds, you’ll simply repeat the process of opening a line of credit.
Lines of Credit vs. Traditional Installment Loans
What is a line of credit loan as opposed to a traditional installment loan? Some loan types are often misinterpreted as being one and the same thing. It’s an easy assumption to make—both lines of credit and traditional installment loans involve extending a specific sum of money to cover temporary costs. Each of these products are also expected to be repaid over set periods of time.
When trying to understand what a line of credit is, it’s important to grasp that while they may seem quite similar, lines of credit and other types of loans each work in different ways, both in how they’re allocated as well as how you repay the balance once it comes due.
A line of credit is a type of loan, but it comes with a much more flexible structure of borrowing. As mentioned above, with a line of credit, you don’t necessarily have to use the full amount of funds that you qualify for—rather, you have the option to do so. You have more autonomy in determining how much to use and when to use it, as opposed to a traditional loan which is generally issued as a full lump sum.
Another important component of a line of credit is its repayment and interest structure. Generally, you only begin to accrue interest once you tap into your funds, and that interest only applies to the amount of credit you actually use. So, if, for example, your line of credit maxes out at $1,000, but you only use $500 of that amount, your interest along with any other applicable fees only applies to the $500 balance. Furthermore, you pay back on only the funds you actually access from your line of credit—in this case, $500 plus interest and/or fees.
With a traditional installment loan, on the other hand, interest begins to accrue immediately on the full value of the loan, and you’re responsible for paying back the entirety of that loan amount. So in the case of your $1,000 loan, interest will begin to accrue on that entire amount the same day you take out the loan, whether or not you spend some or all of those funds right away, and you’ll have to pay back $1,000 plus interest and/or fees.
Essentially, it all boils down to the concept of “access” when thinking about what a line of credit is versus a loan: You receive access to a maximum amount of funds, and you have the option to draw them if needed (and only make payments based on what you draw), instead of receiving an actual lump sum of money with a traditional loan.
What Is a Personal Line of Credit?
A variety of different lines of credit may be available depending on why you need them and what the funds may be used for. These include:
- A business line of credit, intended for as-needed expenses related to your business— such as stocking inventory, purchasing new equipment, or handling unexpected expenses. These are usually unsecured lines of credit and help you avoid having to apply and wait for a full business loan each time you need to make business purchases.
- A home equity line of credit, which is essentially a remortgaging of your home and can be used for repairs or home improvement projects. The amount you may receive for a home equity line of credit is determined, in part, by how much equity you actually have in your home. These lines of credit are secured—meaning you’re putting your house up as collateral.
- A personal line of credit, which is an unsecured line of credit loan meant for uncategorized expenses, is best used for unexpected short-term financial emergencies.
Unless you’re planning a large home renovation or setting up a new business account, the last type of line of credit on this list —the personal line of credit—is likely your most accessible option. So, what is a personal line of credit’s main benefit? As stated, personal lines of credit can be used to help cover a variety of unexpected personal expenses. Some common uses for these kinds of funds include:
- Urgent medical expenses
- Unexpected veterinary treatment
- Emergency car repairs
- Critical home repairs
Making sure you have a financial safety in place in case your emergency fund falls short can pay huge dividends down the road if an unforeseen circumstance leaves you in a pinch and short on funds. A personal line of credit can be a quick and convenient solution to help you handle an emergency.
Opening a Line of Credit
If you find yourself in immediate need of emergency funds, know that opening a line of credit may be done relatively quickly and easily. The process is similar to applying for a traditional loan, and some lenders have moved their application and approval processes entirely online. Some may instead offer a pre-application online, after which you’ll either have a phone or in-person consultation with a loan specialist. In either case, be prepared to provide sensitive information such as:
- Your Social Security number
- Employment and income details
You can usually apply for lines of credit through banks, credit unions, or trusted online loan companies (like MoneyKey). It’s important to first make sure that the lender you’re interested in offers lines of credit in your home state—not all institutions are licensed to do business nationwide. Depending on your lender, you may be required to meet certain eligibility requirements.
For instance, to qualify for a Line of Credit with MoneyKey, we require that you:
- Are a U.S. citizen or a permanent resident of legal contracting age in your state
- Are a resident in a state where our product is offered
- Possess an active bank account with a consistent income source
- Have a valid email and phone number to contact you by
It’s convenient and easy to apply for a line of credit through MoneyKey. And if you still need further details on what a line of credit is and whether it’s right for you, we’re here to help. Contact us with questions and we’ll assist you in any way that we can.