What is a Line of Credit and How to Use it?
Points of Interest
Lines of credit come in three different types — a business line of credit, a personal line of credit, and a home equity line of credit. Each has its pros, cons, costs, and uses.
Whether you’re a business or an individual looking to access money, a line of credit may be an option worth considering. Operating much like a credit card, a line of credit gives you revolving access to money that you only have to pay for if you use it. Lines of credit can be used for funding business costs, paying personal bills and expenses, or making home improvements with your home’s equity.
What is a line of credit?
The easiest way to think of a line of credit and how it works is to think of it as a credit card. The bank or credit union approves you for a certain amount of money, and then you are free to use and reuse that money as long as the line of credit is open. Much like a credit card, you will have an interest rate you pay for the money you use.
Unlike a standard loan, though, you only pay on the money you use. If you never use any of the money, there is no cost to you unless the financial institution charges an origination fee. Generally, this is small, though. Bank of America only charges $50 for unsecured loans up to $100,000. Additionally, lines of credit may give you access to a larger amount of money than you may be able to get with a credit card.
Types of credit lines available
Business line of credit
A business line of credit can be a secured or unsecured loan that gives you access to funds you can use to sustain, build, or grow your business. To qualify, your business will need to meet the eligibility criteria provided by each financial institution. Additionally, you may be required to have your credit checked.
Personal line of credit
Personal lines of credit are generally unsecured lending options that can give you access to large amounts of money at an affordable rate. Generally, these operate much like a credit card with a few differences. Usually, you can keep a credit card open forever. Lines of credit come with a draw period where you can use the funds. After the draw period is over, you can no longer use the funds, and you will pay off the remaining balance in installments. For example, SunTrust has draw periods of four and five years on its lines of credit.
Home equity lines of credit (HELOC)
Home equity lines of credit (HELOC) are borrowing options that use your home and your equity as collateral. If you’ve built up sufficient equity in your home, a lender may let you tap into that with a HELOC.
How to qualify for a credit line
1. Prepare the required documentation.
The application for a credit line is quite similar to the application process for a mortgage or any other type of loan. You will need to collect asset documents, pay stubs, w2s, tax returns, and other financial documents. If you’re getting a business line of credit, you will need documentation about your business, including licenses, P&L sheets, and ownership proof. People looking to get a HELOC will need information on their current mortgage.
2. Research financial institutions offering lines of credit.
All banks and credit unions will offer various lines of credit. Each might offer different rates, lower minimums, and maximum amounts, and many repayment terms. Take the time to shop for the options available to you to find the optimal fit.
Once you’ve found the provider you want to work with, it’s time to apply. Thankfully, you’ve already collected all of the necessary documents in step one, so it should be simple. Many banks will allow you to apply online, or you may be required to go into a branch location with a traditional bank. Approval times and eligibility will vary greatly by different banks and credit unions.
There are a few actions you can do to improve your chances of qualifying for a credit line. First, make sure your credit report is accurate and in order. Lines of credit often require a high credit score, so you’ll want to make sure there are no discrepancies on your report. Second, ensure your paperwork is in order. If you don’t have adequate proof of income and assets, you may find banks struggling to just take your word for it. Start collecting the necessary documentation immediately to streamline the process.
How to use a line of credit
Before you use a line of credit, make sure you completely understand how it works, the repayment process, and the cost of borrowing. Much like any loan, a line of credit is something you should never use without a clear-cut plan for repayment.
Additionally, it’s best to use a line of credit for necessary purchases instead of luxury buys. It’s much better to use a line of credit for a home improvement project than buying a boat or going on vacation. While there are limited limitations on what you can pay for with a line of credit, you still want to maintain fiscal responsibility to protect your financial future.
One drawback to a line of credit is the high creditworthiness requirements needed to secure one. Many banks and credit unions only extend this type of credit to people with great credit. If you’re not in that category, you still have interesting options. Standard credit cards, personal loans, and secured business loans can offer you the affordable funding you need and may be easier to acquire.
The final word
Lines of credit operate much like credit cards, except it can give you access to more money and additional specialized products. These lines of credit are great for people that are unsure of how much money they are going to borrow, but don’t want to get stuck paying for unused money. If you’re looking for funding for your business, home, or personal life, take some time to explore the different options available.