July 22, 2020 | money-management
What Is a Personal Line of Credit?
If you’re looking to borrow money, a personal line of credit may not be the first thing that comes to mind. These are less common than fixed-rate personal loans, which means your friends and family members probably don't have first-hand experience with the lending process. But what makes it different, and when should you consider taking one out?
To help us dig deeper into the ins and outs of personal lines of credit, Amplify Credit Union’s own Consumer Loan Officer, Paige Hanson, offered some insight into this type of loan. We’ll answer some basic questions like:
- What is a personal line of credit?
- How do personal lines of credit work?
- How do you access funds with a personal line of credit?
- What can you use a personal line of credit for?
Here is the Amplify Credit Union primer on personal lines of credit.
What is a Personal Line of Credit?
A personal line of credit is a type of loan borrowed from a financial institution.
Lines of credit often have better interest rates and higher limits than credit cards.”
Unlike traditional personal loans, however, you do not receive the loan amount in one giant lump sum.
“A personal line of credit is a loan that offers a revolving amount of money,” Hanson explains. “It operates like a credit card.” Lines of credit often have better interest rates and higher limits than credit cards, giving consumers a better option when looking for flexible credit.
These loan types are also open-ended, meaning you can borrow from it again and again before you pay down the balance. Better yet, you will only ever pay interest on the amount you borrow.
How Does a Personal Line of Credit Work?
The process of obtaining and using a personal line of credit can be broken down into three simple steps.
Submit an application
Like any other type of personal loan, obtaining a line of credit first starts with an application. According to Hanson, this process can often be more stringent than the typical credit card application. An application for a personal line of credit will require:
- Personal information. This includes your name, address, contact info, and a copy of your government-issued ID
- Your financial standing. Lenders will want to know about your monthly income and want documentation to verify this. They will also need to know about other debts you may have, such as a home mortgage or auto loans.
- Your credit score. Lenders will pull your credit report to take a look at your credit score and history of paying off debt. The amount of debt you already have will also play a factor in determining whether you can borrow.
Most personal lines of credit are considered unsecured loans, meaning you don’t need to have collateral, such as home equity, to back it up. Those with low credit scores or poor credit history may look for secured lines of credit, typically backed by a savings account or CD. Usually, the better your credit is, the better interest rates and higher credit limits lenders will give you.
There are two things you’ll want to keep in mind when it comes to your credit line: the draw period and your credit limit. The draw period is a set period when you can access funds. This window varies from lender to lender, but Hanson suggests most borrowers can expect a draw period of ten years.
The second is your credit limit. While you are not required to borrow the entire qualifying amount, you cannot borrow more than that at once.
Let's say that you have recently been approved for a $10,000 line of credit. If you use $3,000, you can now only borrow up to $7,000 until you’ve paid off your debt. Once you repay the $3,000, your credit limit will be increased to the full $10,000. This is similar to how a credit limit on a credit card works.
Some lenders give borrowers checks or a card to access their funds. Like Amplify Credit Union, others can quickly transfer the funds into your savings or checking account using online banking. Having funds deposited into your account makes things like automatic withdrawals for bill paying a breeze.
Keeping your line open
It’s important to remember that you must use your line of credit if you want to keep it open. Unlike a credit card, which stays open until you close the account, a line of credit closes if it is inactive for a specified period.
“If the line of credit goes a year or more with no use, it will be closed,” Hanson explains. “So if members do get this loan, we recommend they have plans to use it.
Pay off your balance
Some lenders have a draw period and a separate repayment period where you pay off what you borrowed. However, at Amplify, you can start repaying as soon as you borrow. You can avoid the costly prepayment penalties some lenders charge for paying your loan off too early.
What Can You Use a Personal Line of Credit For?
A personal line of credit can be used for just about anything. “A lot of our members utilize these types of loans if they would like to have overdraft protection,” Hanson says. “Another big use for this product is if a member would like to use the loan at their own pace, instead of getting all the funds at once.”
Some members also use this loan to help improve their credit score. “These could also build credit over time with a strong payment history, “Hanson adds.
Some folks use a line of credit as a form of overdraft protection. If you have a fluctuating income, you can use your credit line to pay bills while you’re waiting on your next paycheck. This approach will help you avoid any fees or penalties that happen when you overdraw an empty account.
Some borrowers prefer lines of credit simply because you don’t have to pay interest on the entire sum of money from the beginning. This is a good option that can help keep your costs low if you anticipate needing to borrow money on an infrequent basis.
Like credit cards, lines of credit can be useful tools in building up your credit. Of course, to do this, you’ll need to use it wisely and be diligent about repaying. Borrow only what you intend to use and always be sure you have the means to repay whatever you borrow. Failure to do so can result in a hit to your credit score.
If you don’t have enough equity built up in your home for a home equity line of credit, a personal line of credit can be used to improve your home. This is especially true if you plan on completing these renovations over an extended period.
When borrowing for home renovations, always be sure to check all your options. You may be able to find better rates with loans designed for that purpose, such as a Home Improvement Loan.
Using a Personal Line of Credit for Business
While freelancers and self-employed individuals can use a personal line of credit for business purposes, Hanson warns that there are better options.
“Typically, we like for members to do business loans or lines of credit if they are used for business purposes,” she advises. Personal lines of credit may come with less red tape and more lenient income requirements. Still, there are several downsides to using them for business purposes.
For one, it is usually never a good idea to combine your personal and business funds. Not only can you run into issues when filing taxes, but you also run the risk of damaging your credit score.
When Lines of Credit Aren’t Useful
Even though they can be used in various situations, lines of credit aren’t always the best choice for every scenario. Here are a few instances where a line of credit may not be your best option.
- One-time purchases: If you plan to use a line of credit for a single large purchase, a regular personal loan is likely to give you a better deal.
- Debt consolidation: There’s no need to pay extra for the flexibility that a line of credit offers when consolidating debt. It’s crucial to find the loan with low rates when paying off expensive debt.
- Day to day expenses: Credit cards are often a better option for smaller everyday expenses. As long as you bring your balance down to zero at the end of each month, you won’t face any interest charges. Some credit cards also have exclusive rewards programs that give you cash back for expenses like groceries.
A personal line of credit can be a useful financial tool if you’re looking to borrow money on your terms. It offers flexibility that can save you money compared to fixed-rate personal loans, giving you control over your finances.