What Is a Line of Credit (LOC)?
A line of credit (LOC) is an arrangement between a financial institution and a customer. That establishes the largest loan amount the customer can borrow. The borrower can access funds from the line of credit at any time. As long as they do not exceed the maximum amount (or credit limit) set in the agreement. And also meet any other requirements such as making timely minimum payments.
How Credit Lines Work
All LOCs consist of a set amount of money for borrowing as needed paid back and borrowed again. The amount of interest, size of payments and other rules are set by the lender. Some lines of credit allow you to write checks (drafts) while others include a type of credit or debit card. As noted above, a LOC can be also secured (by collateral). Or unsecured, with unsecured LOCs subject to higher interest rates.
A line of credit has built-in flexibility, which is its main advantage. Borrowers can request a certain amount, but they do not have to use it all. Rather, they can tailor their spending on the LOC to their needs and owe interest only on the amount they draw. Not on the entire credit line. Besides, borrowers can adjust their repayment amounts as needed. Based on their budget or cash flow. They can repay, for example, the entire outstanding balance all at once. Or make small monthly payments.
Unsecured vs. Secured LOCs
Most lines of credit are also called unsecured loans. This means the borrower doesn’t promise the lender any collateral to back the LOC. One notable exception is a home equity line of credit (HELOC). Which is then secured by the equity in the borrower’s home. From the lender’s perspective, secured lines of credit are attractive. Because they provide a way to recoup the advanced funds in the event of non-payment. For individuals or business owners, secured lines of credit are attractive. Because they come with a higher maximum credit limit. And a lower interest rate than unsecured lines of credit. Unsecured lines of credit tend to come with higher interest rates than secured LOCs.
Revocable line of credit. Is a source of credit provided to an individual or business by a bank or financial institution. Which can be also canceled at the lender’s discretion or under specific circumstances. A financial institution may revoke a LOC if the customer’s financial circumstances deteriorate. Or if market conditions turn so adverse on warrant revocation. Such as in the aftermath of the 2008 global credit crisis. A revocable line of credit can be also unsecured or secured. With the former generally carrying a higher rate of interest than the latter.
Revolving vs. Non-Revolving Lines of Credit
A line of credit is often considered to be a type of revolving account, also known as an open-end credit account. This arrangement allows borrowers to spend the money, repay it and spend it again. In a never-ending, revolving cycle. Revolving accounts such as LOC and credit cards are different from installment loans. Such as mortgages, car loans, and signature loans. With installment loans, also called closed-end credit accounts, consumers borrow money. And then repay it in equal monthly installments until the loan is also paid off.
Once you pay off the line of credit in full, the account is also closed and cannot be also used again. Personal LOC is sometimes offered by banks in the form of an overdraft protection plan. A banking customer can sign up to have an overdraft plan linked to his or her checking account. If the customer goes over the amount available in checking. Then the overdraft keeps them from bouncing a check or having a sale denied. Like any line of credit, an overdraft must be also paid back, with interest.
Examples of Lines of Credit
LOCs come in a variety of forms, with each falling under either the secured or unsecured category. Beyond that, each type of LOC has its own characteristics.
Personal Lines of Credit
Provide access to unsecured funds for borrowing, repaying and borrowing again. Opening a personal line of credit requires a credit history of no defaults. A credit score of 680 or higher and reliable income. Having savings helps, as does collateral in the form of stocks or CD’s. Though collateral isn’t required for a personal LOC. Personal LOC’s are also used for emergencies, weddings and other events. Also overdraft protection, travel, and entertainment. And to help smooth out bumps for those with irregular income.
Home Equity Lines of Credit(HELOC’s)
Are the most common type of secured LOC’s. A HELOC can be also secured by the market value of the home minus the amount owed. Which then becomes the basis for determining the size of the line of credit. The credit limit is equal to 75% or 80% of the market value of the home minus the balance owed on the mortgage.
HELOC’s often come with a draw period (usually 10 years). During which the borrower can access available funds, repay them and borrow again. After the draw period, the balance is due, or a loan is also extended to pay off the balance over time. HELOC’s have closing costs. Including the cost of an appraisal on the property used as collateral. Following the passage of the Tax Cuts and Jobs Act of 2017. Interest paid on a HELOC is only deductible if the funds are also used to buy, build or improve the property. That also serves as collateral for the HELOC.
Demand Lines of Credit
These can be either secured or unsecured, but they are rarely used. With a demand LOC, the lender can call the amount borrowed due at any time. Payback is then forestalled or interest plus principal, depending on the terms of LOC. The borrower can spend up to the credit limit at any time.
Securities-Backed Lines of Credit (SBLOC).
These are special secured-demand LOC’s. Whereby the collateral is also provided by the borrower’s securities. An SBLOC lets the investor borrow anywhere from 50% to 95% of the value of assets in his or her account. SBLOC’s are non-purpose loans. Meaning the borrower may not use the money to buy or trade securities. Almost any other type of expenditure is also allowed. SBLOC’s need the borrower to make monthly, interest payments until the loan is repaid in full. Or the brokerage or bank demands payment. Which can happen if the value of the investor’s portfolio falls below the level of the line of credit?
Business Lines of Credit.
Also, provide a way for a business to borrow on an as-needed basis instead of taking out a fixed loan. The financial institution extending the LOC evaluates the market value. Profitability and risk took on by the business and extends a line of credit based on that evaluation. The LOC is either unsecured or secured, depending on the size of the line of credit requested and the evaluation results. As with almost all LOCs, the interest rate is variable.