What is a Line of Credit and How Does It Work?
You know those Personal Finance 101 terms you feel like you should be able to define as a real-life adult — but somehow you have no idea?
Here’s one that comes to mind: line of credit.
Of course we’ve all heard of this, but let’s be honest: A lot of us don’t know the exact definition.
And that’s OK. We’ve got your not-too-intimidating explainer — so you don’t feel silly the next time someone throws those three little words around.
What Is a Line of Credit, and How Does It Work?
A line of credit is simply a way to borrow money. You can take out a line of credit to pay off a medical bill, consolidate your debt, start a small business or make house payments.
In practice, it’s similar to a credit card, says Bruce McClary, vice president of communications at the National Foundation for Credit Counseling.
Here’s how: You’re approved for a line of credit limit, then you borrow against that credit limit as needed and repay it through monthly payments (plus a variable interest rate). The repayment periods tend to be more flexible than other types of loans, and your monthly payment will depend on your lender. Once you pay off what you’ve borrowed, you can continue to borrow against that line of credit for the amount of the term.
Depending on the type of line of credit you need, you’d go to a bank or credit union — or for a home-equity line of credit (HELOC), you’d go to a mortgage lender. More on that later.
Lines of credit fall into two main categories: secured and unsecured.
Secured Line of Credit
This simply means your loan is collateralized. Translated: You offer up personal property to guarantee the repayment of the money you’ve borrowed.
One of the most popular types of a secured line of credit is a HELOC.
“A lot of people who are homeowners will apply for a line of credit,” McClary says.
Their house, then, acts as collateral, so if they don’t pay what they’ve borrowed back, their house is on the line. (No pun intended… seriously.) Thanks to the collateral, McClary points out, secured lines of credit typically come with lower interest rates.
Unsecured Line of Credit
An unsecured line of credit, on the other hand, typically has a higher interest rate because the lender is taking a bigger risk on you. You might feel less accountable without your collateralized property.
Those who aren’t interested in a large line of credit or who don’t want to offer up collateral might take out an unsecured line of credit.
How’s a Line of Credit Different From a Loan or Credit Card?
If you’re still scratching your head, one of the easiest ways to understand a line of credit is to compare it to a loan and a credit card.
Line of Credit vs. Loan
The biggest difference between a line of credit and a loan is how you’re borrowing the money.
When you apply for a loan, you’re applying for a fixed sum. With the most popular types of loans — home, auto and student loans — you apply for a specific amount, and if you’re approved, you’ll receive that entire lump of money.
With a line of credit, on the other hand, there’s more flexibility. You’re granted a maximum amount you can borrow, but you don’t have to use or accept the entire sum. You’ll simply borrow against it.
For example, if you take out a $10,000 line of credit, it’s possible you only use $8,000 of it.
Make sure you can pay off what you use when you take out a line of credit.
Again, with a loan, you’re accepting the entire sum of money and promising to pay it all back.
For that reason, a line of credit could be a better option when you need to borrow an uncertain amount of money, like for home renovations or starting a business, McClary says. Then, you’re not stuck paying off an entire loan — you pay off only what you’ve used.
With both loans and lines of credit, though, you’ll want to shop around and compare rates. For loans, an online loan-comparison marketplace can help you search for lenders offering the best rates.
With a line of credit, you’ll want to look to banks or, for a HELOC, mortgage lenders.
For both, your rates will depend on your creditworthiness.
Line of Credit vs. Credit Card
A credit card and a line of credit share a few more similarities.
“A line of credit is very similar to a credit card, at least in how it works,” says McClary. “The big difference is [a credit card] is designed for maximum convenience. So you’re getting a card… and you take your line of credit with you.”
Both methods of borrowing have limits, but neither requires you to borrow a certain amount. Both are revolving credit: You can borrow and pay back as needed, then borrow more again, during the term of the line of credit.
And with both, you have to keep an eye on how much you’re borrowing to make sure you can pay it off.
It’s worth noting some key differences: With a credit card, you’re paying for convenience, so oftentimes, your interest rates will be higher than that of a line of credit or another loan. The convenience and ease of swiping a card poses a higher risk to the lender.
Lines of credit are also much more likely to be tied to collateral than a credit card and are usually more difficult to qualify for than a credit card; so, the lower rates could be the result of more creditworthy borrowers.
For context, in the first week of February 2020, the national average credit card interest rate was 17.3%, according to CreditCards.com. The line of credit interest rate from Wells Fargo, was 9.5% to 21%. Your actual rate will depend on your creditworthiness, your type of line of credit and how much you want to borrow.
One other difference: Credit cards can offer cash back and other rewards, like sign-up bonuses, to entice you to use them.
Line of Credit (The More You Know)
There’s no reason to feel silly if you didn’t know how to define a line of credit. Now you’ve got the basics down.
But here’s one final tip from McClary:
“Borrowing is a great way to build your credit score and to achieve the highest credit rating you can. But only if you’re managing your debt responsibly. If you manage it responsibly… that’ll help you finance other things you may want to do later in life.”
If you’re curious about your credit score, you can check it for free online. Tap into your credit report to break down what’s going well (and what isn’t). Taking care of your credit score, like McClary said, can help increase your future purchasing power.
If you find yourself in a scramble trying to pay off your line of credit, McClary encourages you to reach out to your lender for options or to contact a local nonprofit, like a credit counseling program, that can help you get your payments back on track ASAP.
The single most important thing you can do, whether you’re borrowing through a line of credit, loan or credit card?
Keep your spending in line. (Get it?)
Carson Kohler ([email protected]) is a staff writer at Codetic. She apologizes for that last pun.