How a Line of Credit Works

A line of credit is a pool of money that you can borrow from as you need. A credit card is a common example of a line of credit, where you have an available balance up to which you can spend. Of course, you need to pay it back and you may be charged interest. A line of credit works differently from a loan because a loan is a lump sum and you may have different terms and interest rates. There are a few types of lines of credit, and you may not have to borrow money from the line of credit (or pay interest on it) until you decide you need the funds.

How Do Lines of Credit Work?

A line of credit is an available balance from which you can borrow money and use before paying it back, sometimes with interest. Different lines of credit work differently.

A credit card allows you to borrow money from your credit line and then pay it back by a certain due date. If you do not pay it back in full by that date, you'll be charged interest. You can have a credit card for years with a revolving line of credit that may go up as your credit score and experience improve.

A home equity line of credit (HELOC) is another type of line of credit. It comes with a draw period and a repayment period.

The draw period is the time that you have access to the credit—that's when you can borrow the money. This stage might last for 10 years or so, depending on the details of your agreement with the lender. The repayment period is when you will repay the principal and interest on the line of credit. However, you will also be expected to make minimum payments during the draw period. A portion of those payments will go toward reducing your interest costs. The portion of your payments that go toward the principal can be added back to your credit line for future borrowing, but this replenishing effect isn't the case with all lines of credit.

The major difference between the draw period and your repayment period is that, when you enter the repayment period, you'll be given a set period within which you're expected to pay off your entire debt.

As you look toward your repayment period, use our loan calculator to understand the long-term cost of your line of credit:

When Should You Open and Use a Line of Credit?

Before you open a new line of credit, it's important to be sure that you can pay it off every month. For example, if you're unsure where your next paycheck will come from, a line of credit may not be wise since you won't be able to pay it off. Of course, you have to do what is best for your financial situation and a line of credit could help you in a time of financial need.

Like any loan, it's rarely advisable to take out a line of credit for "wants" rather than "needs." That means it probably isn't a good idea to use a line of credit to fund a dream vacation or major shopping spree.

A line of credit may be best used for:

• Major purchases
• Financial emergencies
• Home repairs or renovations
• Higher education
• Debt consolidation

If you're taking out the line of credit to help meet monthly expenses, your finances could quickly spiral into debt. Paying for this month's expenses with debt is just going to increase next month's expenses.

Secured and Unsecured Lines of Credits

Lines of credit are typically "unsecured," but some are "secured," which means that the borrower is required to put up collateral. The lender will place a lien against some item of your property, typically your home or your vehicle, but you might also be able to pledge a bank account or a certificate of deposit (CD).

Lines of Credit vs. Personal Loans

A line of credit will typically cost you a bit more in the way of interest than a personal loan would, at least if it's unsecured, but that's not always true. Interest rates may be different from different banks and your personal interest rate will depend on your credit score and report.

Taking out a personal loan involves borrowing a set amount of money in one lump sum. You can't go on paying the principal back and then reusing it as you can with a line of credit. It may also only be something you can use for a set amount of time, with a shorter repayment term than a line of credit.

For example, let's say you take out a line of credit worth up to $10,000. You do not get $10,000 sent to your checking account. You would have a separate way of managing the line of credit and could use the money when needed. You may have a draw period when you can access the money and pay monthly minimum payments. Then you may have a repayment period when you have to pay interest and the remaining principal balance back by a certain date years and years in the future.

On the other hand, let's say you take out a personal loan worth $10,000. You would get the money sent to your account within a few days. You could start using it immediately. You would also need to start repaying it immediately, with a monthly payment made up of a principal amount and an interest charge. The term of the loan may be just a few years long.

Types of Lines of Credit

There are a few main types of lines of credit: home equity lines of credit (HELOCs), personal lines of credit, credit cards, and overdraft lines of credit. Learn more about each below so you can decide which is right for you.

Home Equity Lines of Credit (HELOC)

One of the most common lines of credit for consumers is a home equity line of credit (HELOC). This is a secured loan. Your home's equity—the difference between its fair market value and your mortgage balance—serves as the collateral. Your HELOC forms a lien against your property, just like your first mortgage. Your credit limit is determined by your loan-to-value ratio, your credit scores, and your income.

These lines of credit are popular because they allow you to borrow relatively large amounts at relatively low interest rates compared to credit cards or unsecured loans. Banks consider these loans to be quite safe because they assume you'll repay the line of credit to avoid losing your home in foreclosure. Many homeowners use HELOCs for home renovation, emergency expenses, or other large purchases.

Personal Lines of Credit

A bank may offer a personal line of credit from which you can draw money when needed via an access card or ATM, or written checks. There may be a credit score requirement, a limit on how much you can borrow, and a variable interest rate. Personal lines of credit may be secured or unsecured.

Credit Cards

Your credit card is effectively a line of credit. You get to borrow up to a maximum limit. As you repay what you borrowed, that maximum limit is replenished. You can repeat this cycle of borrowing and repaying numerous times.

One major difference with credit cards compared to other lines of credit is that you'll most likely pay an increased interest rate if you try to take cash. This is known as a cash advance, and it typically comes with different rates than when someone directly charges a purchase at the point of sale.

Another major difference is that you may not have a defined term for your credit card. While a HELOC may have a term of up to 10 years for a draw period, a credit card may be available to you for an indefinite period of time—until you or the credit card provider close the account.

Overdraft Lines of Credit

Another line of credit is the overdraft line of credit. These lines of credit are typically available for your checking account. It's essentially a small loan that is only triggered if you spend more than you have available in your account. The amount of the loan is just enough to bring your account back in the black again. It's usually less expensive than an overdraft fee, assuming you only overdraw by a few bucks. For example, U.S. Bank offers a reserve line of credit for those who may need more money but do not have it in their checking account. Fulton Bank also offers an overdraft line of credit.

Frequently Asked Questions (FAQs)