How does a line of credit work and what are its benefits: When planning a new remodelling project, whether it is for your home or office, or if you need to cover unexpected costs (such as maintenance or repairs to your vehicle), having an option line of credit may be the answer.
A line of credit allows you to access the amount of money you need almost instantly. In most cases, financial institutions, such as lenders, banks, credit unions, and others, offer these instruments. Why is this advantageous? You can use the maximum limit (for a lower amount) and pay it in easy instalments if you qualify.
In this case, you will pay interest only if you use the line of credit, that is, once you apply for the loan. If you return the funds you have requested, you will have access to the maximum limit again. Working with lines of credit has the advantage of being extremely flexible only you decide when to use the money, when to pay it back, or when to reapply.
The lines of credit will be your best friends as long as you adhere to their terms and conditions (such as paying each instalment on time). Discover how they work and how you can take advantage of them!
In summary, a line of credit is an instrument offered by the bank or other financial institution that allows you to access a pre-determined amount of money when you need it. It depends on your needs and the loan limit set by the lender how much money you can request. You will only pay interest if you use the line of credit, so the interest will be calculated based on how much you have requested.
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How do credit lines work?
Let’s talk about the difference between loans and credit lines before diving into this topic. In general, the bank or lender gives you a lump sum of money and, with some exceptions, will charge you interest immediately, regardless of when you spend the money.
As opposed to this, when you work with a line of credit, the bank or lender gives you free access to a fixed amount of money that you can use when you need liquidity or encounter unexpected expenses. In this case, however, interest is not charged immediately upon approval of the line of credit. Interest begins to accrue when the money is withdrawn or requested.
Our focus in this article will be on personal lines of credit, rather than business lines of credit. Business lines of credit are generally not guaranteed. What does that mean? To be able to access them, the financial institution won’t request a guarantee.
The difference between this and business lines of credit is that the latter usually guarantee payment with an asset given as collateral, such as a property or a savings account.
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What are the steps to applying for a line of credit?
Each bank or financial institution will have its own application process, but generally speaking, the approval of a credit line is based on your credit score. The higher your credit score, the more chances you have of getting a high credit limit on your line of credit. You’ll also be able to fix lower interest rates with a good credit score.
You will also have to pay according to the terms of the credit line offered by the bank or cooperative. Some of them require monthly payments, others work with annual payments, and the majority determine a maximum amount we can use on our credit cards.
You will have a fixed term to use the money if you qualify for the line of credit, known as the withdrawal period. It is the time limit that the grantor sets to keep the line open. Withdrawal periods usually range from 1 to 5 years, but can be longer.
How do you receive the money and when do you start running interest?
What happens if a withdrawal period ends before a debt is paid?
Nothing happens technically. At this point, you will be in the refund period. The bank or lender will give you a certain amount of time to pay off the remaining balance. As a result, you will not be in default or in default: you will only have a credit that will work similarly to a personal loan over the short- or medium-term.
Remember: Making only the minimum payments will result in higher interest payments. You can avoid this by paying in micropayments or monthly subscriptions.
Characteristics of a line of credit
Lines of credit are financial products that have very specific characteristics that set them apart from others. Here are a few of them:
- Although we will have the entire amount requested, we will only access what we need at any given time.
- There is a short return period.
- Interest is only paid on the money we use, starting at the moment it is withdrawn.
- Lines of credit will also accrue a small amount of interest. It is extremely low.
- You can also link a credit card to it.
- The reason it is designed for short-term situations is that it is more expensive than a loan.
Financial expenses with the line of credit
Financial expenses associated with the line of credit are solely based on the amount of capital available to the user. Let’s take the example of a credit card with a limit of $10,000. If the person used $5,000 and the interest rate is 2%, the interest payable would be $100.
In addition, it is important to mention that the creditor may charge a commission if the client has not used all or part of the loan. This depends on the regulations in each country.
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The main elements of a line of credit
The following are the main components of a line of credit:
- Maximum amount available: Maximum amount available to the customer.
- Maturity: This is the date at which the line of credit is completed. This period is usually one year, but it can be longer if the contract specifies so.
- Interest rates and expenses: Different expenses will be passed on to the client according to what is stipulated in the contract. Generally, the main expense is the interest rate paid on the cash withdrawn.
Advantages of a line of credit
The following are the main benefits of lines of credit:
- Flexibility: The client has the right to dispose of the money whenever he wishes during the term of the contract. Additionally, you can set disposition amounts as you see fit, as long as you don’t go over the pre-set limit.
- Ease: It operates in the same way as a checking account. The financial institution deposits the money in a client’s credit account, facilitating management by the client. Because it is similar to a current account, the money can be accessed quickly.
Disadvantages of a line of credit
One of the main drawbacks of a line of credit is the expense the client may incur:
- Expense of formalization of the contract: It usually takes place before a notary, so it is an extra expense for the creditor.
- Opening commission: If one is applied, it usually represents a percentage of the total amount.
- Interest on the provision: This is the basis on which the financial institution performs this type of contract. An interest rate is determined by the amount the other party uses.
- Interest on the undisposed: It is possible that it is also specified in the contract. The interest rate is based on the amount the client has not used in comparison with the total available. It will be lower than the rate set for the amount drawn.
- Excess interest: When the client exceeds the amount drawn from the available limit, interest is due. The interest rate for this type of loan is usually higher than that for the amount borrowed.
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How do credit lines affect credit scores?
As you apply for a line of credit, your total credit will increase, allowing you to borrow more. As a result, this positively impacts your credit score, since it shows that you have the financial capacity to cover your expenses. As a result, if you use all the money on your line of credit, your credit score could decline. How come? This could give the bank the impression that your financial solvency is not as high as it seems.
Paying your debts and instalments on time will not be a problem as long as you pay the debts on time and the points will only be reduced by a few points. If you never use available credit, or commit to using just a small percentage of the total amount, your credit utilization rate will decline, resulting in a higher credit score. Conversely, if you request a high percentage of the approved limit as a loan, the credit utilization rate will increase, resulting in a lower credit score.
Your credit score will be affected if you miss a payment on your line of credit, just like any other loan, debt, or credit card.
Types of lines of credit
Lines of credit are generally divided into two types: secured lines of credit and unsecured lines of credit. Let’s see what they are:
Secured Lines of Credit
You might consider applying for a home equity line of credit, better known as a HELOC, if you’re looking for a secured loan.
You can apply for a loan based on your home’s current value through a Home Equity Line Of Credit (HELOC). Your house will be used as collateral by the bank or lender. In general, HELOCs work with variable interest rates, which means payments can fluctuate over time.
However, the bank will not take into account 100% of your home’s value for the guarantee. Generally speaking, appraisals are located at 85% of the value of a property. This figure is also deducted from the remaining first mortgage balance on the house.
Banks use a number of factors to determine your loan interest rate, including your credit score, payment history, and your income.
Don’t worry if you don’t own a home or don’t want to put your home under warranty! As collateral, you can place your savings account or a certificate of deposit against a line of credit.
Do secured credit lines have any disadvantages? Certainly. In the event that you cannot make the payments, the lender may make the guarantee effective and your house, savings account, or certificate of deposit would become their property.
Unsecured lines of credit
In some cases, you may be required to pay an annual fee (similar to credit card maintenance) in order to maintain your line of credit.
What is the difference between a credit card and a line of credit?
Credit cards and lines of credit have many similarities. Both instruments are revolving credit instruments, which means that you can use up to the maximum limit of the money, pay the amount plus interest, and request another amount as a loan in the future.
This confirms the fact that credit cards and lines of credit are two different products:
- Credit cards do not have a withdrawal period. As long as the expiration date has not passed, the plastic is in good shape and they are not suspended, you can use them whenever you like. In addition to reward programs, loyalty programs, and points, many credit cards are available in the market. You may even be able to avoid interest charges if you pay your balance on time (and your credit card has a grace period). They are therefore one of the best options for daily consumption, provided they are used responsibly, of course.
- In contrast, credit lines charge interest on a daily basis based on an annual interest rate. The APR is typically lower than that of credit cards. Therefore, it may be cheaper for you to use this credit type. Credit cards also have lower credit limits than personal lines of credit. If you require cash now, lines of credit would be the best option since, although you can request an advance with your credit card, you would have to pay a series of commissions and fees that do not apply to lines of credit.
Difference between a line of credit and a regular loan
Free disposal is the first difference between a line of credit and a regular loan. As explained above, in the first case there is no need to use the entire approved balance.
In contrast, if we refer to a common loan, we grant a fixed amount of money. Capital must be returned depending on the method of financial amortization selected, for example, in equal instalments.
The issue of renewal should also be considered. Lines of credit can be replenished indefinitely. As soon as a loan is repaid to the creditor, it is extinguished.
It should also be noted that the interest rate on a loan is lower than that on a credit line.
We can therefore conclude that when high financing is needed and the credit cannot be repaid in the short term, it is advisable to utilize a loan.
Instead, a line of credit is suggested when a current balance is needed. The money can be used for current expenses (services, food, etc.) or for long-term investment projects, such as a progressive office equipment upgrade. Suppose, for example, that the individual purchases items for their work space or furniture every month.
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Tips for using a line of credit effectively
Check your credit record by requesting a copy of your credit report before signing up for a secured or unsecured line of credit. You can improve your credit score by changing some of your financial habits if you need to. This will improve your chances of qualifying for a line of credit with a low annual interest rate.
Before requesting money, calculate how much you would need and what you would like to invest it in.
According to Bruce McClary, vice president of communications for the National Foundation for Credit Counselling (NFCC), lines of credit are one of the easiest and most flexible ways to obtain a loan. McClary does add, however, that “if you are taking out a loan to get out of another loan, there is a financial problem you must solve. In this case, taking out a line of credit would not be the best solution since you would be entering an endless cycle of payments.
When to use a line of credit?
When investing the money in a remodelling or upgrading job, paying education expenses or other important expenses; a HELOC or secured line of credit would be a wise choice, especially if you are confident you will be able to cover the refund. An added bonus? The interest you pay on the HELOC is tax deductible.
In this way, you will be consolidating all of your debts into one and -the best thing- at a much lower interest rate. If you have several small debts with higher interest rates, you can pay them off with a HELOC or an unsecured line of credit.
When not to use a line of credit?
This is usually the case if you are uncertain about your ability to pay the loan or your income is unstable. If you do not meet the payments, your score will be affected as well as the rate applicable to your line of credit. Additionally, if you posted collateral, you could lose it entirely.
You should not pay more in interest if you have other more attractive financial options, such as an unsecured personal loan with a better interest rate than the line of credit. If you have better payment options available, you should not pay more in interest.
Spending money from a line of credit for basic needs, luxuries, or expendable expenses is not recommended. Dining out, going on vacation, or paying rent are examples of expenses that should not be covered.
In the event that you are unable to pay them with your income, you may be experiencing financial difficulties and should avoid taking on new debt.
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Why use a Line of Credit?
In the business sector, lines of credit are widely used. It is a very useful source of funding for companies in order to manage their treasury more efficiently. Using this method allows the Treasury to make payments on time that would not otherwise be possible. Salaries and wages, payments to suppliers, unforeseen expenses, etc., are examples.
It is advisable to use it only when cash is short. In other words, poor estimates of cash flows that are offset by this source of financing.
Is this a good financing option?
Well, as with everything related to debt, the answer is “it depends”. It can be an interesting option if you use it occasionally to cover unexpected expenses when you don’t have the liquidity to cover them. However, it is not the best choice for individuals, freelancers, or SMEs seeking regular financing. It is important to avoid debt wherever possible.
Summary
Lines of credit are ideal for those seeking financial flexibility, as they allow you to access a fixed amount of money when you need it. However, just like any banking instrument, they are not without their risks.
That if you don’t pay on time, you could negatively affect your credit score or give the bank an excuse to raise your interest rate on your loans. You could even lose what you have pledged as collateral, such as your home or savings account.
It can be a headache to have easy access to a certain amount as a loan, especially if you already have financial difficulties. To avoid any problems, make sure you invest the money in your line of credit wisely and pay your bills on time.
Now that you know what a line of credit is and how it works, you can find out if you qualify for this product. This will enable you to obtain the financing you need. In order to maintain a clean credit history that will allow you to access other lines of credit or bank loans in the future, make sure you pay your instalments on time. Always save before spending.
Having doubts? Feel free to post them in the comments section!!
