One of the lesser-known and lesser-used options is a line of credit. Businesses have been using lines of credit for years to meet working capital needs and/or take advantage of strategic investment opportunities, but they’ve never quite caught on as much with individuals. Some of this may be due to the fact that banks don’t often advertise lines of credit, and potential borrowers don’t think to ask. Here, then, are some of the basics about lines of credit.
What it Is
A line of credit is basically a flexible loan from a bank or financial institution to an individual or business. Not unlike how a credit card offers you a limited amount of funds that you can use when, if, and how you wish, a line of credit is a limited/specified amount of money that an individual can access as needed and then repay immediately or over a pre-specified period of time. As a loan, a line of credit will charge interest as soon as money is borrowed, and borrowers must be approved by the bank (and such approval is a byproduct of the borrower’s credit rating and/or relationship with the bank).
Banks have only recently begun to market these products to any significant extent. This may be a byproduct of an economy that has reduced loan demand and new regulations that have restricted fee-based sources of income. Lines of credit tend to be lower-risk revenue sources relative to credit card loans, but they do complicate a bank’s earning asset management somewhat, as the outstanding balances can’t really be controlled once the line of credit has been approved.
When a Line of Credit is Useful
A line of credit addresses the fact that banks are not terribly interested in underwriting one-time personal loans, particularly unsecured loans, for most customers. Likewise, it is not economical for a borrower to take out a loan every month or two, repay it, and then continue the cycle. Lines of credit answer both of these issues by making a specified amount of money available if and when the borrower needs it.
By and large, lines of credit are not intended to be used to fund single one-time purchases such as houses or cars – that is what mortgages and auto loans are for – though lines of credit 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 the same basic purpose as business lines of credit – to smooth out the vagaries of variable monthly income and expenses, and/or to finance projects where it may be difficult to ascertain the amount of funds needed upfront.
Consider a self-employed person whose monthly income is unpredictable or where there is a significant (and/or unpredictable) delay between performing the work and collecting
the pay. While this might normally be a situation where people would turn to a credit card, a line of credit can be a cheaper option (lower interest rates) and offer more flexible repayment schedules. Lines of credit can also be useful in these situations to help fund estimated quarterly tax payments, particularly when there is a discrepancy between the timing of the “accounting profit” and the actual receipt of cash.
Lines of credit can be useful in situations where there will be repeated cash outlays, but the amounts may not be known upfront and/or the vendors may not accept credit cards, and in situations that require large cash deposits – weddings being one good example. Likewise, lines of credit were often quite popular during the housing boom to fund home improvement or refurbishment projects – people would frequently get a mortgage to buy the dwelling and simultaneously obtain a line of credit to help fund whatever renovations or remodeling were needed.
Personal lines of credit have also appeared as part of bank-offered overdraft protection plans. While not all banks are particularly eager to explain overdraft protection as a loan product (“it’s a service, not a loan!”) and not all overdraft protection plans are underpinned by personal lines of credit, many are. Here again, though, is an example of the use of a line of credit as a source of emergency funds on a quick, as-needed basis.
The Problems with Lines of Credit
Like any loan product, lines of credit are both potentially useful and potentially dangerous. If investors do tap a line of credit, that money has to be paid back (and the terms for such paybacks are spelled out at the time when the line of credit is initially granted). Accordingly, there is a credit evaluation process and would-be borrowers with poor credit will have a much harder time being approved for a line of credit.
Likewise, it’s not free money. Unsecured lines of credit – that is lines of credit not tied to the equity in your home or some other valuable property – are certainly cheaper than loans from pawnshops or payday lenders, and usually cheaper than credit cards, but they’re more expensive than traditional secured loans such as mortgages or auto loans. In most cases, the interest on a line of credit is not tax deductible.
Some, but not all, banks will charge a maintenance fee (either monthly or annually) if you do not use the line of credit, and interest is charged 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 and may surprised at what they end up paying in interest after they borrow from a line of credit.