A line of credit is like a credit card. You have a fixed amount you can borrow and interest only starts to accrue when you start using the credit. And when you repay the loan, your line of credit is renewed.
But before you decide to open a line of credit, read on and learn the basics so you know whether or not it’s the best option for you.
A line of credit is a predefined amount of money that you have been authorized to borrow from a bank, credit union or other financial institution. You can borrow as little or as much as you need, up to the maximum amount offered. You will be charged interest on the amount borrowed until you have repaid the balance.
Sometimes it’s easier to describe how a money transfer works with concrete examples. So let’s look at a situation where a line of credit is often considered.
There are secured and unsecured lines of credit. With a secured line of credit, you provide collateral to secure the loan. Let’s say you decide to apply for a home equity line of credit.
The collateral – or security – is the equity in your home. With a secured line of credit, the interest rates can be quite good because it’s less risky for the lender. But the downside is significant: if you don’t repay as agreed, the lender can repossess your home.
In contrast, a personal line of credit is unsecured, which means there is no collateral. And since there is no collateral, it is more risky for the lender. This means that the interest rates on your unsecured line of credit will be a little higher than those on a secured line of credit.
Here is an example of an unsecured line of credit: You want to renovate your house, but you don’t know how much it will cost. You therefore request a line of credit from your bank, which allows you to tap into the money you need during your renovations. To your delight, you have been approved for a $20,000 line of credit from your bank.
After about a month, you’ve used $15,000 for the renovation project. Your line of credit is now $5,000. But you are now paying interest on the borrowed money, so at least make minimum monthly payments. As you repay your balance, your line of credit increases by the amount repaid.
The details differ from institution to institution, but you usually have a set period of time to access your line of credit. At the end of the draw period, you continue to work to repay the borrowed money.
If you want to apply for an unsecured personal line of credit, you must first estimate the amount you may need to complete your project or pay off your debt. You can then start researching your options.
But before you apply for a line of credit, you need to make sure your credit is in good shape.
Since a personal line of credit is unsecured, you will need good or excellent credit to be approved. So before you apply, check your free annual credit reports and credit score to see where you stand.
You’ll need a top notch credit score to get the best rates. I’ve seen what is considered a prime score fluctuate over the years, but here are the ranges according to the Consumer Financial Protection Bureau:
- Deep subprime: credit scores below 580.
- Subprimes: 580-619.
- Quasi-prime: 620-659.
- First: 660-719.
- Super bounty: 720 or more.
As you can see, a near-prime score starts in the mid-600s, but if you’re in that category, it’s harder to get a line of credit.
Now keep in mind that a line of credit is considered a revolving account, like your credit cards. Overusing your line of credit or making sloppy payments could lower your credit score. Set up reminders or automatic payments so you don’t forget to make a monthly payment.
One of the biggest benefits of a line of credit is getting funds quickly. And if you have good credit, you’ll get a good interest rate. Manage your line of credit responsibly and it could boost your credit score.
But the opposite can happen if you are not careful. I’ve seen people get in over their heads with a line of credit when they were using it for the wrong reasons.
For example, don’t start thinking of this as your personal emergency fund. In fact, if you don’t have an emergency fund with at least six months of expenses, put any home improvement projects on your list and get your fund back in good shape.
If you’re using a line of credit to pay off credit card debt, consider a balance transfer credit card first. A consumer with a super-prime credit score (720 and above) will most likely qualify for a 0% APR introductory offer on a balance transfer credit card. There are often 3% to 5% fees associated with balance transfer cards, so add that to the total you will pay on a balance transfer credit card.
Decide what your monthly payment needs to be (amount transferred plus any fees applied) to pay it back – or at least down – during the introductory period. Most 0% APR balance transfer offers range from 12 to 21 months. This is a great opportunity to get rid of your debt while paying no interest during the introductory period.
Each establishment has its own rates and guidelines. You can check with your bank if a line of credit is available. But even if that’s the case, I recommend researching other options online and comparing rates. On many websites you can get an overview of your rate and payments. Also look for the fees that are involved. For example, most lines of credit have annual fees.
After researching your options and choosing a bank or credit union for a line of credit, be prepared to provide some or all of the following: home address, employer information, income, tax returns, bank statements and other relevant financial information.
Response times are usually pretty quick, so if you’re approved, you won’t have to wait long to access the funds.