Are you planning on renovating your house over the next several years, but you don't
know how much it will cost? Perhaps you foresee long-term medical costs that
may not be completely covered by your insurance. Maybe your twin daughters
surprised you by getting accepted to Ivy League schools, and you need to fill in
the financial gap. A line of credit is one financial strategy to tackle large
and unpredictable or variable costs.
A line of credit is a type of loan that doesn't give you one giant injection of
funds the way a traditional loan does. Like a credit card, you draw on the
credit when you need to pay for something that is financially out of reach.
Unlike most credit cards, the interest rates on lines of credit are generally low,
and the limits tend to be high.
There are several reason why a person may choose a line of credit over a traditional
loan. With a traditional loan, you get a chunk of money and immediately begin
paying the loan back, regardless of when you actually use the money. But a
line of credit lets you borrow the amount you need when you need it. With
most lines of credit, you make payments only on the credit you've actually used.
Let's explore the types of lines of credit and which factors decide whether
or not you'll qualify for one.
Types of Lines of Credit
Two main types of lines of credit are available to money-seekers: the personal line
of credit and the business line of credit. With both types, the financial
institution that provides your line of credit will set a limit on the credit, similar
to a credit card limit. Personal lines of credit are secured by the person's
property. Personal property, such as a house, is the collateral that the lender
can seize if the individual fails to pay back the loan.
The most common line of credit, and therefore the best example of how lines of credit
work, is the home equity line of credit (HELOC). When you get a HELOC from
your mortgage lender or other financial institution, you have a set period of time
during which you can draw on the line of credit. This period is aptly named
the draw term. During this term, you use checks, a special credit card or
another method to use the money in your line of credit. Since HELOCs are long-term
lending agreements, draw terms tend to be around 10 years.
During the draw term, interest will accrue at a rate determined by the line of credit's
interest rate. Most lines of credit have a variable interest rate based on
the prime rate plus a margin. For example, you might see a home equity line
of credit offered at the prime rate plus percent or 2 points. The interest
rate for the line of credit will always be 2 percent above the prime rate.
When the prime rate changes, so does your interest rate.
How you make payments on your HELOC depends on the financial institution's offer.
You might make monthly payments that go toward paying off both interest and principal.
Or you might make payments only on the interest. In the latter situation,
you would have to pay back the principal (the total amount you borrowed) at the
end of the draw term. Alternatively, your lender might set up a repayment
plan at the end of the draw term, which would allow you to pay back the principal
in installments.
In principle, business lines of credit do not differ much from personal lines of
credit. Like a HELOC, a business line of credit can also be an equity line
of credit, which means the credit is based on your ownership interest in something.
Instead of using personal property for collateral, however, a business line of credit
is secured by your business's assets. These assets might be business real
estate, company vehicles or even office furniture. Just like a person may
use a line of credit to pay for something big, like tuition at a private school,
a business may use a line of credit to pay for a large cost, such as an expansion
into the building next door or a company-wide software upgrade.