How does a Line of Credit Work

A line of credit is the maximum amount that is extended by a financial institution to its clients for business or personal reasons. A line of credit is preferred by businesses and individuals since interest is charged on the amount used, rather than the amount sanctioned. It provides the benefit of borrowing upto a certain limit for a pre-determined period of time, without having to apply for loans on a continuous basis.

Both business and personal lines of credit, can be secured or unsecured. A secured line of credit is backed by a collateral and in case of default, the lending institution confiscates the collateral. An unsecured line of credit is not backed by a collateral. In case of an unsecured line of credit, the credit history of the borrower and credit scores assume a great deal of importance. It is generally difficult to obtain an unsecured line of credit and the interest rate charged on it is also high. Both secured and unsecured personal and business lines of credit generally have a variable interest rate structure.

Types of Lines of Credit

Secured Personal Lines of Credit

The best example of a secured personal line of credit is the home equity line of credit (HELOC). All of us are aware of the 30-year fixed rate level-payment mortgage that helps us buy our first home. The collateral for the 'first mortgage' is the home which would revert to the lending institution in case of default. Sometimes, one might require additional credit for the purpose of repairs, home improvements or education. In such a situation, a second mortgage is usually sought. The main disadvantage of a second mortgage is that one is forced to pay interest on the entire amount sanctioned even if it not used. A better alternative would be to apply for a home equity line of credit since one is required to pay interest on the amount borrowed rather than the amount sanctioned. This is made possible by providing a credit card that allows the person to borrow up to the credit limit.

Disadvantages of Secured Personal Lines of Credit

The main disadvantage in case of a HELOC is the variable rate of interest on the borrowed amount. The variable rate of interest is generally based on the prime lending rate. Since the rate of interest is floating, it is required by law to have an upper limit on the interest. This ceiling is called the cap. In case of a shortage of funds, the prime lending rate increases and results in an increase in the our variable interest rate. In case the new rate exceeds the allowed cap, the line of credit starts functioning like a fixed rate loan. The HELOC also has a period after which further borrowings are not allowed and one must pay off the amount borrowed. Some HELOC's also charge an additional fee that has to be paid off at the end of the borrowing period.

Secured (Asset Secured) Business Lines of Credit

Secured business lines of credit are an important way of meeting the working capital requirements of a business. The assets of the company function as the collateral. The main advantage of this is the ready availability of cash without having to apply for loans on a regular basis. Again, interest is charged only on the amount utilized since withdrawals are done using a credit card. The business entity has the flexibility to pay the entire amount due or the minimum charge that accrues on the credit card.

Unsecured Personal Lines of Credit

Unsecured personal lines of credit are also provided by various banks in the U.S. Withdrawals are done using credit cards that have a high (Annual Percentage Rate) APR. In this case, the credit history and credit score of the person seeking the line of credit assume a lot of importance. It may not be a good idea to consider an unsecured line of credit if one intends to build a good credit score. This is because the amount we owe decides 30% of the FICO score while 10% of the FICO score is dedicated to new credit.

Unsecured Business Lines of Credit

These are less popular than secured business lines of credit since they would require a minimum FICO score of 680. In addition to this, the profitability of the business, age of the business and the obsolescence of its products will also be scrutinized in great detail before allocating such a line of credit. The APR is again much higher than the secured line of credit.

Seeking a line of credit is sometimes unavoidable, however one should try and asses the general direction of the interest rates since they play a major role in determining the interest rate on the line of credit. If the interest rates on the Treasury bonds increase, the prime lending rate increases. This increases the interest rate on the lines of credit sometimes forcing the borrower to pay exorbitant interests and plunging him into deeper debt.