What Is a Line of Credit & How Does It Work?

A line of credit is a pre-approved loan that allows you to access the money you need when you need it.

The money can be used for whatever you want – home improvement, a vacation, even buying a car. A line of credit (LOC) is different from a loan in that you borrow portions of it as you need the money. You only make payments on what you’ve borrowed, not the total amount you’re allowed.

As with loans, there are two types of line of credit: secured, as in a home equity line of credit (HELOC), or unsecured, which don’t require collateral.

Line of Credit Types

The most common lines of credit fall under three categories: personal lines of credit, business lines of credit and home equity lines of credit.

Personal Line of Credit

Since a personal line of credit (PLOC) is an unsecured loan, similar to a personal loan, you need a credit score in the upper-good range — 700 or more — and a history of on-time debt payments to qualify. Debt-to-income ratio and your income will also play a part. The amount you’ll be approved for depends on those factors.

A PLOC is more like a credit card than a loan, in that you only pay interest on the amount of money you borrow, not the full amount of the credit line. Also similar to a credit card, with many personal LOCs, as you pay it back that money becomes available again to borrow, so it’s revolving credit. During the draw period, there is a minimum monthly payment, but you can pay more. Once the draw period is over, there will be a payback period.

Interest rates are almost always lower than those of your credit cards. Most personal LOCs have variable interest, so payments may be different each time you use the money.

Home Equity Line of Credit (HELOC)

A home equity line of credit (HELOC) is a loan secured by the equity in your home, which is defined as the home’s market value minus what you owe on your mortgage.

Lenders won’t approve a loan in the amount of the full value of your equity but use the combined loan-to-value (CLTV) ratio, which usually equals 80% or less of your equity. Even so, you’re putting your house at risk when you borrow on a HELOC, so consider the ramifications carefully.

Interest is usually in line with that of mortgages, so it would be lower than what you’re paying for credit cards. It’s also usually lower than that of a personal line of credit, and the limit is often higher since it’s based on your home’s equity.

If you use a HELOC for home renovations, the interest is deductible. It’s not deductible if you use it for other purposes. Before tax law changed in 2017, interest was deductible, no matter the use. Those changes expire in 2025 but may be renewed.

Business Line of Credit

A business line of credit is similar to other lines of credit, with one big exception: It must be used only for business expenses.

Interest rates are usually lower than that of a business credit card. A business credit line can be secured by your business assets, or unsecured. Most require an annual review and renewal, but can generally be used for years as long as you don’t exceed your credit limit.

When applying, a traditional lender usually wants to see two years of business profit and loss statements, and assets, as well as look at your personal finances. Online lenders may be more flexible, and new businesses may be eligible, although good credit will still be a factor.

Secured vs. Unsecured Lines of Credit

If you’re considering a line of credit, you may be wondering if you should get one that’s secured – usually a HELOC – or an unsecured one.

Secured lines of credit usually have lower interest, and higher spending limits, and are easier to qualify for because the lender can seize your property if you don’t pay it back. That means secured lines of credit are riskier for the borrower since you can lose your home, or whatever other collateral is attached if you can’t repay it.

Examples of a secured line of credit are:

• HELOC: Your home is the collateral, and the amount you get is determined by its equity.
• Savings-secured LOC: You deposit an amount in a savings account, and draw on it. As you make on-time payments, the amount you can borrow increases. It’s great for people trying to build credit.
• Securities-backed LOC (SBLOC): If you invest in securities, the securities firm may allow you to use them as collateral on a line of credit.
• Pre-paid credit card: You to borrow from yourself, by loading the card with your own money, then using it like a credit card. There’s no interest, but lenders that allow overdrafts will charge a fee. It’s a good way to rebuild credit or to use it for instances when you need a credit card.

Credit cards are the most common form of unsecured LOC. But if you’re looking for lower interest and a limited draw period, you can apply for a personal LOC with a lender.

Personal LOCs have lower interest rates than credit cards, and a specific draw period when you can use them is usually 5-10 years. They also are more difficult to get than a credit card. You must have good enough credit and a high enough income to reassure the lender that you’ll be able to make payments. While you’re not putting your house or other collateral at risk, 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

Lines of credit can either be revolving or non-revolving.

Revolving credit lines are open-ended, meaning that throughout the draw period, you can keep borrowing against your limit. The amount available to borrow increases as you make payments and replenish the money that’s available.

The drawback is that if you don’t pay off the balance each month, you end up paying much more in interest as it continues to accumulate. This is why your credit card balance may never seem to go down, even though you’re making payments.

Non-revolving credit lines are closed-end, similar to loans because your repayments don’t replenish the account. In that way, they’re similar to a personal loan, mortgage or car loan. The difference from a loan is that you don’t have to take all the money at once, but it’s different from a revolving line of credit in that the total you borrow during the draw period can’t exceed the initial limit of the LOC. If you borrow the entire amount, and pay it all back, the LOC is closed. You can’t borrow more.

How to Get a Line of Credit

Lines of credit usually have lower interest rates than credit cards, and offer cash when you need it, so are more financially efficient than a lump-sum, single-purpose loan. With a credit line, you can borrow in increments, repay it, and borrow again.

Repayments during the draw period are usually minimal, sometimes just the interest, which makes it different from a conventional loan, which has fixed monthly payments.

You can apply for a personal line of credit in person at your local credit union or community bank – having a relationship with these lenders may help get you approved. There are also countless online lenders. Be sure to shop around and understand what you’re applying for. Be warned, too, that if you hit a button that offers to “check your rate” on a LOC or HELOC, you will be immediately inundated with texts, phone calls, and emails from lenders. Don’t let it overwhelm you or feel you have to reply. Do your homework on the best-rated ones and what they offer before making contact.

If a personal line of credit will meet your needs, and you’ve done your homework, make sure you’re ready to apply for one:

• How do I apply for a personal credit line? A personal LOC is unsecured, so the bank is taking a bigger risk than if you have collateral. You will have to convince the lender that you’re a good risk. Review your credit reports from the three credit bureaus – Experience, Transunion and Equifax – so you know your credit history and credit score. Never having defaulted on a loan, or not having defaulted in years, helps. Having a high credit score also shows creditworthiness. Gather two years of tax returns, six months of W2s, and any other documents related to your income and credit. Be sure when you apply to include all sources of income and your savings.
• How large a credit line should you request? The larger your credit line, the greater risk you pose to the lender, as well as to your own finances. Hold your requested amount to what you realistically need to borrow, keeping in mind your income and ability to repay the LOC. The lender will ultimately determine what you qualify for, based on your credit history and income, but if you don’t need that amount, don’t apply for one that high.
• What credit scores and collateral might be required? A strong credit score and credit history are key to being approved for a personal LOC. Credit scores, assigned and updated by the nation’s three credit-rating agencies, range from 300 to 850. The higher your credit score, the better the terms of your loan. While banks vary, a credit score under 700 may make it difficult to get a personal LOC, or may mean higher interest and fees. If you own a home, you’re your credit score is below 700, it may be easier to get a HELOC, rather than a personal line of credit.

When you apply for an LOC, pay close attention to the repayment options. Both types, but non-revolving lines of credit in particular, may require you to make periodic principal and interest payments, or even pay the entire principal at the end of the draw period.

Is It Worth Getting a Line of Credit?

You may be considering getting a line of credit to take care of some home improvement issues, consolidate debt, take a vacation, or even just have access to money in case you need it. Everyone’s financial situation is different, and ultimately the decision on whether it’s worth it to get a line of credit is up to you and your wallet.

But there are some general pros and cons of getting a line of credit to keep in mind.

Advantages of a Personal Line of Credit

• Access to money as you need it.
• An emergency fund for large unexpected expenses.
• Lower interest rates than credit cards.
• You only pay interest on what you’ve accessed.
• Convenient for home improvement or other projects where cost isn’t certain.
• With a revolving LOC, as you repay it, the balance available to you expands.

Problems With Personal Lines of Credit

• You need strong credit and reliable income to qualify.
• Because it’s unsecured, Interest rates are higher than for a secured LOC or loan.
• Interest rates are variable, so they may change.
• It’s easy to overspend, with the money so readily available.
• The lender may charge transaction fees, or a monthly administrative fee even if you’re not using the LOC.

A line of credit can influence your credit score, for better or worse, 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 — that’s a high credit usage, which has an impact on your credit score. The credit bureaus like to see credit usage of 30% or below. If you make payments that keep the balance low, it will help your credit score. On-time payments and low credit utilization help a credit score, but having a different type of credit does as well. The greater variety in the types of credit you’re paying on, the more it helps your score.

Before you sign on the dotted line, make sure you fully understand the agreement. This includes maintenance fees (usually annual, sometimes monthly), repayment schedule, and prepayment penalties, as well as any other payment terms.

Line of Credit Alternatives

Your credit, income and even what you need the money for, may make a line of credit not as good an option as some of the alternatives.

Some alternatives to a personal line of credit are:

• HELOC: You may not want to risk your home as collateral for a personal line of credit, but if you own one and have a nice amount of equity, you will likely get a lower interest rate than with a personal line. Depending on how much equity you have, you may also qualify for a higher limit. If you use the money for home improvements, it will be tax deductible. You will also have an easier time qualifying if your credit score is lower than what’s needed for a personal LOC.
• Personal Loan: With a loan, you borrow the full amount of money at once, unlike a line of credit, where you only take as much out as you need. That means possible higher payments and less flexibility on when you use the money. But a loan also has a set period for the payback, the payment amount doesn’t change, and the interest is fixed, not variable.
• Credit Card: A credit card is easier to get than a personal line of credit, but the interest will likely be much higher. The credit limit will also likely be lower than that of a personal line of credit.
• Debt Consolidation: If your primary purpose of a personal line of credit would be for debt consolidation with a lower interest rate than what you’re paying on credit cards, consider a debt management plan or other debt consolidation method that doesn’t involve continuing access to money, revolving credit and variable interest rates.

A personal line of credit may be perfect for your financial needs. If it is, be sure to use it wisely and build a stronger financial foundation for you and your family.