A line of credit is a lending arrangement between a financial institution (usually a bank or credit union) and either a business or an individual. A credit account is extended to the borrower with a maximum credit limit to borrow against. A line of credit is different than a mortgage or auto loan because the money does not have to be used for a pre-specified purchase. It is almost like a credit card, only without the plastic. Lines of credit come in both secured and unsecured forms, and there can be significant differences between the two.
Secured Lines of Credit
When any loan is secured, it means that the credit grantor has established a lien against an asset that belongs to the borrower. This asset becomes collateral, and it can be seized or liquidated by the lender in the event of default. Perhaps the most common example of this is a home mortgage, in which the bank agrees to lend you a large sum of money against the property itself.
From the lender's perspective, secured lines of credit are attractive because they provide a way to recoup the money in the event of non-payment. For individuals or business owners, secured lines of credit are attractive, because they typically come with a higher maximum credit limit and significantly lower interest rates than unsecured lines of credit.
One very popular secured line of credit is a home equity line of credit (HELOC). With a HELOC, money is borrowed against either
the value of the equity in the home or a second mortgage, each of which establishes a lien position for the creditor.
Unsecured Line of Credit
Technically, credit cards are the most common type of unsecured credit line. No asset is acting as collateral against the lent funds in an unsecured line of credit, so the lending institution is assuming a much larger risk.
The additional risk to the creditor makes unsecured lines of credit difficult to approve. However, none of the borrower's major assets are subject to seizure upon default.
Unsecured lines are particularly difficult for businesses that want to open lines of credit for possible capital expansion. In this circumstance, the funds are borrowed against the possibility of future business returns. Lenders usually only consider such a loan to established companies with excellent reputations as debtors.
Lenders attempt to compensate for the increased risk of unsecured loans by limiting the amount of funds that can be borrowed and by charging higher interest rates as a premium on their assumed risk.
Both secured and unsecured lines of credit have advantages over regular loans: flexibility of purchases, no set monthly payments or regular payment dates, and no interest charged on unused credit in the account. If you opt for a revolving credit line, any repayment immediately makes those funds available for credit again, which is useful if you want a long-standing, multifunctional credit account.