What Are Lines of Credit & How Do They Work?

A line of credit is a pre-approved loan that allows you to get money when you need it and not all at once. These credit lines are sometimes backed by an underlying asset, such as a mortgage, and they’re often flexible in how they function. A home equity line of credit (HELOC) is secured by the collateral of a home, while a personal line of credit is usually unsecured.

You can use all of a credit line at once, or you can take it in smaller portions as you need the money. Homeowners often use credit lines to fund home improvements, paying down the balance a month at a time. Families sometimes use credit lines to fund more expensive vacations.

Most lines of credit have a defined borrowing and payback period, typically 5-10 years. At the end of the term, you must pay off your balance or else renew the line of credit with updated terms.

Lines of credit come in two forms: unsecured and secured. The first relies entirely on your perceived ability to repay the loan. Lenders review your credit score, credit history, and provable income. The other backstops the loan with something of equal or greater value, like your home or some other form of property.

Line of Credit Types

There are a few types of lines of credit, including personal lines of credit, business lines of credit and home equity lines of credit.

Personal Line of Credit

A personal line of credit is an unsecured loan. That is, you ask the lender to trust you to make repayment. To land one, you’ll need to present a credit score in the upper-good range — 700 or more — accompanied by a history of being punctual about paying debts.

Similar to a personal loan or a credit card, an unsecured personal line of credit gets bank approval based on an applicant’s ability to repay the debt. Your credit score, credit history and income are key factors.

The amount available to a borrower varies from person to person — and, of course, the applicant’s perceived need. Don’t apply for a $250,000 line of credit when $25,000 will do.

Uses for a personal line of credit:

• Emergency expenses: The roof springs a big leak; your car’s transmission blows up; medical bills.
• Long-term projects: renovating a kitchen, adding a mother-in-law suite, paying for college or a wedding, restoring that 1957 Corvette.
• Cash-flow management: bridging the gaps for earners of irregular income.
• Debt consolidation: grouping credit card and other consumer debt into a single loan.
• Rare life experiences: the cruise of a decade, playing the great golf courses of Scotland, taking a French cooking school vacation and restoring that Corvette

Shop and bargain with lenders for the best interest rate. Also, watch out for the impact of tack-on fees, such as an annual fee simply to keep the account open. A sizable annual fee may offset an alluring low interest rate.

Two pieces of good news about personal lines of credit: You only pay interest on the amount of money you borrow, and interest rates are almost always lower than those of any credit card in your pocket. Banks often tie credit lines directly to a fluctuating market index or the current prime rate, so the interest rate for your borrowing can be different each time you use the money.

A word of caution. Pawn brokers and payday lenders sort of fall into the universe of personal lines of credit — they don’t care how you spend your loan, only that you pay it back, and they’re happy to have your repeated business — but their fees and interest rates can be staggering. Better to stick with reputable financial institutions.

A personal line of credit resembles a credit card:

• There’s a specific amount you can borrow against (much like the limit on most credit cards).
• You may use it for any purpose.
• You may use it whenever you want.
• You can pay off the balance over a long period.
• And in most cases, as you pay off the balance, you free up the loan amount to borrow against again. (This is the classic definition of “revolving credit.”)

Home Equity Line of Credit (HELOC)

A home equity line of credit (HELOC) is a loan secured by the equity in your house. Your equity is defined as home’s market value minus its outstanding mortgage balance.

Rarely can you borrow against all the equity in your home. Instead, lenders apply a formula to the maximum size of a HELOC, expressed as the combined loan-to-value (CLTV) ratio.

Assume you have applied to a lender that offers a maximum CLTV ratio of 80%. You’ve lived there a while and the neighborhood has experienced rising values. Your home is worth $400,000 and you owe $150,000 on the first mortgage. You may qualify to borrow up to $170,000 ($400,000 x 0.80 = $320,000; $320,000 – $150,000 = $170,000).

Again, the lender’s primary concern will involve whether the applicant is a worthy risk. How you spend the money is of no consequence … to the lender. Your bank won’t ask questions about what you pay for. But you should have smart financial reasons to erode your home equity.

One key use for a HELOC: home renovation projects. Not only will the project add value (thus, equity) and livability to your dwelling, the IRS allows itemizers to deduct some the interest paid on a HELOC (up to $750,000 for combined mortgage debt for married-filing jointly taxpayers).

The uses mentioned above for unsecured lines of credit are also in play. Because you’re putting your house on the line, you’ll likely score a better interest rate — it should be close to first-mortgage refinancing rates — than for an unsecured line of credit.

Business Line of Credit

A business line of credit works like other lines of credit: Reuse and repay as often as you like, as long as your account is in good standing and you don’t exceed your credit limit.

Limits on business lines of credit are usually lower than term loans, typically ranging from $1,000 to $250,000. They’re also usually unsecured, which means collateral — inventory, real estate — doesn’t come into play.

Lenders make decisions based on personal and business tax returns, bank account information, and business financial records, such as profit-and-loss statements and a balance sheet.

Thinking about going the online route? Upside: Internet business lenders often have looser qualifications than traditional lenders. Downside: Credit limits may be lower, interest rates higher.

To qualify, the business will have to exist for at least six months and show $25,000 in annual revenue.

If a business can qualify, a business line of credit offers flexibility that a traditional term loan can’t.

How to Get a Line of Credit

Personal LOCs often come with lower interest rates than credit cards, making them a superior choice for borrowing. They also offer variable access to cash instead of a lump-sum, single-purpose loan. A credit line allows you to borrow in increments, repay it and borrow again as long as the line remains open. Typically, you will be required to pay interest on borrowed balance while the line is open for borrowing, which makes it different from a conventional loan, which is repaid in fixed installments.

If you conclude that a line of credit best meets your needs, prepare your case before approaching a lender:

• How do I apply for a credit line? Personal lines of credit are unsecured, which means you don’t need to offer collateral to protect the lender if you default. That makes it different from home equity lines of credit (HELOCs), which are secured by the equity in your home. Since risk is a key facet of lending, interest on a LOC almost certainly will be higher than on a HELOC. Therefore, it’s crucial to convince the lender you are a good risk. Never having defaulted on a loan, or not having defaulted in years, helps. Having a high credit score also shows creditworthiness. You should also let the lender know about all sources of income and your savings, which can help establish you as a good risk.
• How large a credit line should you request? The larger your credit line, the greater risk you pose to the lender. You should probably hold your requested amount to what you realistically need to borrow, keeping in mind your income stream and ability to repay the borrowed money. Lenders will evaluate your creditworthiness using several metrics, including your credit score, your loan repayment history, any business risks you might have, and your income. Each influences the size of the credit line.
• What credit scores and collateral might be required? Because banks often base personal LOCs on income and credit history, having a strong credit score is important. Credit scores, assigned and updated by the nation’s three large credit-rating agencies, range from 300 to 850. The higher your credit score, the better the terms of your loan.

Problems with Personal Lines of Credit

Though there are many attractive sides to personal lines of credit, as with every loan, there are trouble spots to consider. The top two: getting approved for the loan and the interest rate banks will charge.

Lines of credit are unsecured loans. That means the bank is taking a risk. The bank has to be certain the borrower has a credit history that shows (s)he will pay back the loan. Therefore, expect everything in the customer’s credit report to be scrutinized closely.

This must be said: If you have a poor credit score or credit history, it will be very difficult for a lending institution to extend you a LOC.

Because there is no collateral defending the lender against the loan going bad, the interest rates on a line of credit are higher than mortgage or car loans. This does not mean you can’t score an attractive rate. In 2023, many online lenders advertised rates below 8%. Among all lenders, the average rate was about 10.8%, but your mileage may vary, depending on your credit and income situation.

Another trouble spot: Unlike typical term loans, rates on personal LOCs are variable, making them subject to the whims of the marketplace. They can change year-by-year, depending on the terms of the loan agreement.

Also, be aware that a line of credit can influence your credit score, depending on how you use it. If you draw a high percentage of the amount borrowed — taking $9,000 of the $10,000 available, for example — your credit usage will hurt your credit score. Likewise, taking below 30% of your draw is considered good use, boosting your score.

At the risk of repeating ourselves: Study the proposed LOC maintenance fees (usually annual, sometimes monthly). Understand the repayment schedule. Study the contract, making certain you grasp all the payment terms before agreeing to a LOC.

Are there prepayment penalties? You need to know.

Secured vs. Unsecured Lines of Credit

There are two types of credit lines: secured and unsecured.

A secured credit line is one in which the borrower uses an asset, usually a car or home, as collateral to secure the loan. The lender can take the asset if the borrower doesn’t repay the debt. Because of the asset, banks and creditors usually offer lower interest rates, higher spending limits, and better terms on secured lines of credit.

Unsecured lines of credit need no collateral. A creditor accepts the risk that a borrower will repay the debt. It’s usually difficult to get an unsecured LOC approved unless you are a well-established business or someone with an excellent credit rating. A long relationship with a bank or credit union also helps.

Secured Credit Lines

HELOCs are a widely used form of secured credit lines. HELOCs use equity in real estate as collateral and are really second mortgages attached to credit lines.

Examples of secured credit lines include:

• Home equity line of credit (HELOC): You can use the money for anything, but home-improvement projects are popular use.
• Vehicle loans: We live in a car culture, and it’s tough to do without one.
• Pawnshop loans: People who have an immediate need for cash try these, but there’s a risk of losing a possession you adore, especially if it takes you too long to repay the loan.
• Life insurance loans: You can borrow against whole life insurance policies and use the money for whatever you desire.
• Savings-secured loans: Also good for unrestricted spending.
• Pre-paid credit cards: Unlimited uses, but it’s difficult to get a card with more than $500 on it. But you can buy multiple cards.

Unsecured Credit Lines

Credit cards are the most common form of unsecured lines of credit. Personal LOCs often come with lower interest rates than credit cards, and the difference might be considerable. Personal LOC lenders can offer advantages, such as flexible repayment schedules, that most credit cards don’t.

Examples of unsecured credit lines include:

• Credit cards: You can put most of your daily purchases on a credit card. In many cases, you can generate rewards points.
• Personal lines of credit: These are usually not for day-to-day spending but for projects, such as a home-improvement upgrade.
• Personal loans: These are also for projects and bigger one-time purchases, such as for a home appliance.
• Peer-to-peer loans: These are often friend-to-friend loans that are unregulated.
• Payday loans: These are for emergency debts that must be paid immediately. High fees and the inability to repay these on time lead financial advisers counsel people to find other ways to borrow money.

If you don’t repay an unsecured debt, the lender may hire a debt collector or sue to collect.

Revolving vs. Non-Revolving Lines of Credit

Just as there are two forms of credit lines (secured and unsecured) there are also two functional ways they operate: revolving and non-revolving.

Revolving Credit Lines

Revolving credit lines are also called open-end credit. The amount that you use, or borrow, can be different each month. And you rarely have to pay off the balance at the end of the month. That means you can carry a balance from one month to the next, although interest makes the amount you owe grow.

Gas station and department store credit cards are revolving credit lines. So are most Discover, VISA and MasterCard credit cards.

Any loan that allows a consumer to borrow portions of the credit limit charges interest only on the outstanding balance and frees up credit as the balance is paid down, amounts to revolving/open-end credit. The consequences of being unable to pay a credit card minimum payment are late fees, damage to your credit report, and penalty interest rates.

Home equity lines of credit (HELOCs) are revolving lines of credit. The amount you can borrow is based on a percentage of your home’s appraised value (usually 70%-80%), minus the amount still owed — our friend the combined loan-to-value ratio.

Non-Revolving Credit Lines

Non-revolving credit lines, also called closed-end credit lines, provide a fixed amount of money to finance a specific purpose and period. The loan may require periodic principal and interest payments, or payment of the entire principal at the end of the loan term.

Examples of non-revolving credit lines are most real-estate loans, auto loans, appliance loans and payday loans, which are small, short-term loans secured against a customer’s next wages.

Other Revolving Credit Sources

There are some lesser-known sources of revolving credit lines.

Overdraft protection on checking accounts is considered a revolving source of credit.

Some revolving personal checking lines also are available in some banks and credit unions. Banks and credit unions establish credit limits and deposits limit money in the bank for you to write checks against instead of you depositing money into an account and then writing checks against that amount.

Travel and entertainment cards (T&E cards) are popular with people who travel frequently. Cardholders use them to pay for car rentals, dinner, golf, tennis, spa visits and access to airport lounges. Diners Club and Carte Blanche are two T&E cards. They must be paid off each month.

Similarities and Differences with Other Loans

There are many differences between a line of credit and personal loans. The primary one is that money gets disbursed in an as-needed draw in a LOC. With a loan, money gets disbursed all at once.

Another difference: the interest rate on a LOC is usually variable, and the interest you pay gets calculated only on the amount of money you use. A loan usually carries a fixed interest rate, and monthly payments are based on the full loan amount.

A line of credit is usually unsecured and carries terms that are more favorable for the borrower.

The one similarity between a line of credit and a loan, such as a payday loan, is that both involve a lender. But the LOC is superior in every other way. In fact, a line of credit is distinctive enough to make it worth investigating.