Similar to how everyone chases after the same trendy fashion brands or waits in line to grab a table at popular tacos spots, when people need money, they lean towards the most popular options: loans, credit cards, or borrowing from friends and family.
Many overlook lines of credit and aren’t exactly sure what they are.
Line of Credit Definition
Let’s start with the basics: what is a line of credit?
Simply put, a line of credit is a set amount of money that a financial institution (like a bank or credit union) gives you access to. Typically you can make withdrawals on this amount over a given period (a draw period).
You might find yourself needing a line of credit at several phases of your life. Although lines of credit, loans, and credit cards may sound similar, there are key differences between the three.
Loan vs. Line of Credit vs. Credit Card
With a loan, you get one lump sum of money and start paying interest on it immediately, regardless of when you use the money. If you’re going to take out a loan, you should always have a plan for paying it back as quickly as possible.
Credit cards are very similar to lines of credit in that they give you access to money, and you only pay interest on the money you use. To clarify, like the relationship between squares and rectangles (sorry for the 10th grade flashbacks), all credit cards are lines of credit, but not all lines of credit are credit cards.
With a line of credit, your money doesn’t have to be attached to a physical card. You can request a transfer and have cash deposited into your bank account. You’re charged interest once the money’s borrowed.
When you secure a line of credit, you can make plans for how you’d like to use it and borrow the money when you’re ready to. Having a line of credit is super helpful because it gives you access to funds you may need and diversifies your credit portfolio (or credit mix).
You can use a line of credit for various circumstances; emergencies, home improvements, or other big purchases. There are different kinds of credit lines for different needs.
Secured Vs. Unsecured Line of Credit
Secured credit is a type of loan wherein the borrower provides collateral to obtain the credit. An example of this is when a person offers their home as collateral for the loan itself.
Secured lines of credit are less risky for the lender, which can allow you to secure a higher borrowing amount, as well as a lower interest rate.
Imagine you left your Nerf gun at home and want to borrow someone’s bike to go pick it up. You may let them hold your rare Pokemon card, so that they know you’re coming back with their bike. In this case, you are the borrower, the bike is the line of credit, the owner of the bike is the lender, and your Pokemon card is the collateral.
An unsecured line of credit doesn’t require collateral. Without collateral, a lender is at greater risk, meaning they’ll often grant smaller borrowing amounts with higher interest.
In unsecured situations, you don’t have a Pokemon card on you to offer as collateral, so nobody’s going to give you their bike; at most, they’ll let you use their scooter.
Most times, your credit score will play a significant role in the final decision as to whether or not you’ll be approved.
Open-End Vs. Close-End (AKA Revolving VS Non-revolving)
An Open-end line of credit allows the borrower to make repeated withdrawals and payments throughout the draw period. You may have heard of revolving credit; this is the same thing as an open-end line of credit.
Credit cards are an excellent example of open-ended credit lines. You can swipe your credit card, make a payment, and then swipe your card again. Once you pay back the amount you’ve drawn against the credit line, the money becomes available to borrow from again.
Open-end credit is a flexible way to fund financial projects that cost significant amounts over time.
A closed-end (non-revolving) credit line provides a borrower with a specific amount of money to use for a particular product or service in full.
For example, you can use a closed-end credit line to buy a fridge. Not dinosaur magnets to put on it or child locks to keep your cat out, just the fridge.
Closed-end credit is less flexible than open-end credit because it serves a specific purpose, and you have to use it in one lump sum. Once repaid, you cannot draw from this line of credit again.
You’ll be lent closed-end credit for a fixed amount of time. Typically, you’ll need to make scheduled payments on principal and interest, starting immediately after borrowing the money.
A personal line of credit is one used for personal matters. Personal lines of credit are typically revolving and unsecured. Although collateral isn’t required, getting qualified for a line typically depends on your income and credit history.
A personal line of credit is an excellent option when you’ll need a significant sum of money over a certain period, like when making home improvements or heading off for college.
If you’re looking for a personal line of credit, you’ll need to have a good credit score. Your lender needs to have confidence in your ability to manage and repay borrowed credit.
Credit Mix Diversification
A good credit score depends on several factors, including your credit portfolio and your ability to make minimum payments. Having a diverse credit portfolio (or credit mix) accounts for 10% of your credit score.
You may have found yourself in the cycle of needing a credit score to receive lines of credit but needing lines of credit to receive a credit score. That’s where credit-earning debit cards come into play.
But wait… you thought that debit cards don’t help build your credit score. Well, think again.
Extra is the first debit card that lets you build a credit history just as you would with a credit card. The Extra card will be a crucial player in your credit portfolio. Extra lets lenders know that you’re good at managing debt despite you not having any (you’re beating the system!)
With the Extra debit card, you’re only able to spend money that you have, meaning you’ll never be in debt and will always make your payments in full. Once your credit score is strong, you’ll be able to secure a line of credit and diversify your portfolio even more.
Personal Line of Credit vs. Personal Loan
The difference between a personal line of credit and a personal loan is the interest payments.
As previously stated, with a loan, you have to start paying interest on your borrowed money as soon as it’s received. With a line of credit, interest is charged once the money’s withdrawn.
Personal lines of credit are more flexible because they ensure you’re only paying interest on what you use and owe rather than the entire lump sum.
A Home equity line of credit (HELOC) works similarly to a personal line of credit. The main distinction between the two is the need for collateral.
To be eligible for a HELOC, you need to offer your home as collateral, just as you do with a secured line. The amount of money you’ll have access to is based on the equity you have in your home, not the overall value of the home itself.
Similar to a personal line of credit, interest charges on your HELOC will only begin when you make withdrawals. The amount of money you’d like to borrow will often determine whether you use a HELOC or a personal line of credit.
Interest rates for HELOCs tend to be variable, meaning they can fluctuate throughout the life of the draw period. Always read through terms carefully and ask as many questions as you need to before securing your credit line.
With each of the different types of credit lines: open vs. closed-end, secure vs. unsecured, there’s one with similar terms to use for your business. Mixing your personal and business finances isn’t always advised and can make budgeting that much more challenging.
By learning which kind of credit line works best for you and would work best for your business, you can continue to invest in various projects. In the same way that a personal line of credit can help you with life, a business line can help you grow your business.
Credit Lines In Summary
Credit lines are super useful tools that can help you in various ways. These are the four key concepts that you should take with you from this blog:
- Credit lines are more flexible than loans because you only start paying interest on them when you withdraw money
- Open-ended credit lines are great for when you’re going to need money over time
- Secured credit and HELOCs require that you put up collateral
- Having a good credit score and diverse portfolio is essential in any instance that you’re going to borrow money
The bottom line is that lines of credit give you access to money when you need it most. Borrowing money is a big deal so you should always know what options are available to you and use them wisely.