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Line of Credit - How a Line of Credit Works

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Overview:

A line of credit is a pool of available money that you can borrow. When you get a line of credit, you get the ability to draw up to the maximum limit.

Home Equity Lines of Credit:

The most common line of credit for consumers is a home equity line of credit. You use your home equity as collateral. The bank assumes that you'll repay the line of credit to avoid losing your home in foreclosure.

Your credit limit will be determined, in part, by your loan to value ratio.

Line of Credit vs Home Equity Loan:

Generally a home equity line of credit (or HELOC)is more flexible than a home equity loan. You only borrow what you need, and you can typically go back for more money when you need to (as long as you stay below your maximum credit limit). You might use a checkbook to access your line of credit. A second mortgage typically involves a single loan that you repay over time. A line of credit will have a variable rate, while second mortgages can have a fixed or variable interest rate.

Draw and Repayment Periods:

Your line of credit will have a draw period and a repayment period. During the draw period, you borrow money and use your line of credit. This may last for 10 years or so. During the repayment period, you repay principal and interest on the loan (see How Amortization Works).

Closing Costs:

Like most loans, lines of credit have closing costs. Factor these in when you make your decisions on lenders and loan types.

Overdraft Line of Credit:

Another type of line of credit is the overdraft line of credit. These help you avoid overdraft fees in your checking account.
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