Lines of Credit: When to Use Them and When to Avoid Them This loan option can provide versatility, but there are risks to consider By STEPHEN D. SIMPSON Updated January 31, 2023 Reviewed by ERIKA RASURE Fact checked by SUZANNE KVILHAUG
When you need money, you may consider getting a personal loan, which provides a lump-sum amount. However, if you don’t know exactly how much money you may need, you may want to consider a line of credit.
A line of credit is essentially a revolving loan that allows you to access the money you need as you need it, up to a certain limit. As the money is repaid, you can borrow up to that limit again.
Learn more about what a line of credit is, about the different types, when to avoid them, and how to use them to your advantage.
KEY TAKEAWAYS
A line of credit is a flexible loan from a financial institution that consists of a defined amount of money that you can access as needed.
You can repay what you borrow from a line of credit immediately or over time in regular minimum payments.
Interest is charged on a line of credit as soon as money is borrowed.
Lines of credit can be used to cover unexpected expenses that do not fit your budget.
Potential downsides include high interest rates, late payment fees, and the potential to spend more than you can afford to repay.
What Is a Line of Credit?
A line of credit is a flexible loan from a bank or financial institution. Similar to a credit card with a set credit limit, a line of credit is a defined amount of money that you can access as needed and use as you wish. Then, you can repay what you used immediately or over time. As with a loan, you will pay interest using a line of credit. Borrowers must be approved by the bank, which considers credit rating and/or your relationship with the bank, among other factors. Lines of credit tend to be lower-risk than using a credit card, but they are not as common. Unlike with personal loans, the interest rate on a line of credit is generally variable, meaning it could change as broader interest rates change. This can make it difficult to predict what the money you borrow will actually end up costing you.1
When a Line of Credit Is Useful Investopedia / Michela Buttignol Lines of credit are not intended to be used to fund one-time purchases such as houses or cars, though they can be used to acquire items for which a bank might not normally underwrite a loan. Most commonly, individual lines of credit are intended for unexpected expenses or to finance projects that have unclear costs. Lines of credit can be useful in situations where costs may not be known up front. They can also be useful for major expenses like weddings or home improvements. Personal lines of credit may also be part of an overdraft protection plan.2
The Problems with Lines of Credit
Like other loan products, lines of credit have benefits and risks to consider. If you tap a line of credit, that money has to be paid back, so make sure that you can afford to make those repayments. If you have poor credit, you may not get approved for this product. Personal lines of credit are often unsecured, so they are not tied to collateral, which means that they can be more expensive than other types of loans, such as mortgages and auto loans. Home equity lines of credit (HELOCs), however, do use your home equity as collateral. Some banks will charge a maintenance fee (either monthly or annually) if you do not use the line of credit, and interest starts accumulating as soon as money is borrowed. Because lines of credit can be drawn on and repaid on an unscheduled basis, some borrowers may find the interest calculations for lines of credit more complicated. You could be surprised at what you end up paying in interest. Comparing Lines of Credit to Other Types of Borrowing
Lines of credit have similarities and differences compared to other financing methods like credit cards, personal loans, and payday loans. Credit Cards
Like credit cards, lines of credit have preset limits in that you are approved to borrow a certain amount. Also, like credit cards, policies for going over that limit vary with the lender. Also similar to a credit card, a line of credit is essentially preapproved, and the money can be accessed whenever the borrower wants for whatever use. Lastly, while a credit card and a line of credit may have annual fees, neither charges interest until there is an outstanding balance. Unlike credit cards, some lines of credit can be secured with real property, such as with home equity lines of credit (HELOCs).3
Credit cards will always have minimum monthly payments, and companies will significantly increase the interest rate if those payments are not met. Lines of credit may or may not have similar immediate monthly repayment requirements. Personal Loans
Like a traditional loan, a line of credit requires acceptable credit and repayment of the funds and charges interest. Also like a loan, using a line of credit responsibly can improve a borrower’s credit score. You can use funds from personal loans and lines of credit for any purpose you like. However, a loan is typically for a fixed amount for a fixed time with a prearranged repayment schedule. In contrast, a line of credit has more flexibility and usually has a variable rate of interest. When interest rates rise, your line of credit will cost more, whereas payments for a fixed loan remain the same.1 Payday and Pawn Loans
There are some similarities between lines of credit and payday and pawn loans, including the fact that you can use the funds as you would like. The differences, however, are considerable:
For anyone who can qualify for a line of credit, the cost of funds will be dramatically lower than for a payday or pawn loan.
The credit evaluation process is easier with a payday or pawn loan (there may be no credit check at all), and you get your funds more quickly.
A line of credit is generally much larger than a payday or pawn loan.
How do I qualify for a line of credit?
To qualify for a line of credit, you will have to meet the lender’s standards, which typically include proving your creditworthiness with a minimum credit score, sufficient income, and other factors. What are the disadvantages of a line of credit?
With any loan product, you can run the risk of getting into more debt than you can manage. If you cannot pay off the credit that you use, then your credit score will decline. If a line of credit has a variable interest rate, you also risk the interest rate rising, which would mean that you would pay more in total interest. How do you pay back a line of credit?
You pay back a line of credit by making the minimum monthly payment to the lender. You will receive a monthly bill that includes your advances, interest, and fees, You may be required to pay off the entire balance each year.4
The Bottom Line
Lines of credit, like any financial product, have advantages and disadvantages, depending on how you use them. On one hand, excessive borrowing against a line of credit can get you into financial trouble. On the other hand, lines of credit can be cost-effective solutions to fund unexpected or major expenses.
As is the case with any loan, shop around and pay careful attention to the terms—particularly the fees, interest rate, and repayment schedule.
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