Lines of credit: What they are and how they work
A line of credit is a type of account that allows a borrower to withdraw money and repay it over and over again as long as the account is open and in good standing.
Learn more about different kinds of credit lines, how they work and how they could affect your credit scores.
What you’ll learn:
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Lines of credit are typically revolving accounts, which work similarly to credit cards. But there are some nonrevolving lines of credit.
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Lines of credit can be unsecured or secured, depending on whether collateral is required.
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Examples include personal lines of credit, home equity lines of credit and business lines of credit.
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Like many loans, approval decisions for lines of credit are typically based on borrowers’ creditworthiness.
What is a line of credit?
Lines of credit are types of loans borrowers can use and then repay again and again up to a preset limit or pay off a set amount over time, at which point the account is usually closed. Lines of credit are typically available at financial institutions such as banks and credit unions. Some lines of credit are for personal use, while others are for business expenses.
How does a line of credit work?
There are several different types of lines of credit. And they can work differently depending on the terms and conditions of the account.
Generally, a line of credit has a set credit limit. The account holder can borrow and repay money up to that limit. Lenders typically set the credit limit based on the borrower’s creditworthiness. Lines of credit also usually charge interest, at either a fixed or a variable rate. And many lines of credit require minimum monthly payments.
Some lenders may provide checks or a card linked to the credit line that can be used to access funds.
Revolving vs. nonrevolving line of credit
Lines of credit can be either revolving accounts or nonrevolving accounts.
With a revolving line of credit, a person can borrow money and then make payments on an ongoing basis as long as they don’t exceed the account’s credit limit. As they use the line of credit, the amount of available credit goes down. As they pay it back, the available credit goes back up.
When borrowing money from a nonrevolving line of credit, the available credit doesn’t go back up once an account holder repays the debt. After it’s repaid, the account typically will be closed. This kind of account can also be referred to as installment credit.
Secured vs. unsecured line of credit
Lines of credit can be secured or unsecured accounts. With a secured line of credit, borrowers provide collateral such as a car or home to back the loan. If they don’t repay the funds, the lender can take the asset that was used as collateral.
Unsecured lines of credit don’t require collateral. For this reason, they may have higher interest rates than secured lines of credit. They may also require higher credit scores.
3 types of lines of credit and their requirements
Here are common types of credit lines, plus requirements borrowers may need to satisfy for each:
1. Personal line of credit
Personal lines of credit (PLOCs) could refer to unsecured, revolving loans taken out for personal use. Similar to a credit card, a PLOC might be used for things such as financing a large purchase or accessing cash. Terms for a PLOC vary depending on the lender. And to approve a PLOC, lenders often require a strong credit history and an open checking account with the same financial institution.
PLOCs work differently because they’re a type of installment loan. This means the borrower gets a lump sum up front then pays it back in equal monthly payments over a set period of time.
2. Home equity line of credit
Home equity lines of credit (HELOCs) are a type of secured credit account, allowing a borrower to draw money against the equity they have in their home.
When applying for a HELOC, lenders typically request an appraisal to assess the home’s value. From there, the lender will determine the credit limit, which averages 80% to 85% of the home’s market value.
If someone is approved for a HELOC, they can draw against their home’s equity during what’s known as a draw period. Draw periods vary depending on the agreement, but 10 years is a common time frame. During the draw period, they can access and repay funds over and over again as long as purchases stay within the limit.
3. Business line of credit
Business lines of credit can be used by organizations to cover their operating costs and other business-related expenses. Depending on the agreement, they could be secured or unsecured. Collateral for secured business lines of credit could include:
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Property
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Equipment
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Inventory
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Investments
Pros and cons of lines of credit
As with any kind of loan or credit, there are some potential benefits and impacts of taking out a line of credit.
4 line of credit benefits
Some possible upsides of a line of credit may include:
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Convenient, flexible access to funds
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Relatively low interest rates
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Options that don’t require collateral
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May be used for overdraft protection
4 potential downsides of lines of credit
Lines of credit may also have potential impacts to consider, including:
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Borrowers with low credit scores may have a hard time qualifying for some lines of credit.
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Fees, including origination fees and maintenance fees, may apply.
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Interest may not be tax deductible.
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Lines of credit may not provide the same protections as credit cards.
Does a line of credit affect your credit scores?
Applying for, opening and using a line of credit can affect your credit scores in a number of ways. Here are some major factors involved in credit scoring that may be affected:
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Payment history
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Debt
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Credit age
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Credit mix
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New credit applications
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Credit utilization
Exactly how a line of credit affects your scores depends on the credit-scoring model and when your scores are calculated. And when you apply for any new credit account, it may trigger a hard inquiry, which can cause your credit scores to drop temporarily.
Line of credit FAQ
Want to learn more about lines of credit? Here are answers to a couple of frequently asked questions:
How do you get a line of credit?
You can apply for a line of credit from lenders that offer them, including banks and credit unions.
The application process may be similar to that of other loans or credit applications. Lenders generally review your creditworthiness to determine whether you’re eligible. And the higher your credit scores, the more likely you may be to get a line of credit with lower interest rates.
Before applying, consider comparing things like annual percentage rates (APRs), fees and other costs related to opening and using the account.
How do you pay back a line of credit?
Lines of credit typically require minimum monthly payments. Similar to credit cards, you might receive a monthly statement showing a breakdown of what you owe. That balance could include the money you borrowed plus any interest and fees.
Key takeaways: Lines of credit
Lines of credit are one way to cover large or unexpected expenses. Before taking out a line of credit, make sure to look into things like fees, interest and how it will impact your budget.
Credit cards are another way to get convenient, flexible access to funds. Some credit cards can also offer advantages, such as rewards, over a line of credit. If you’re new to credit or searching for your next credit card, Capital One can help:
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See if you’re pre-approved for credit cards without harming your credit scores.
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If you’re looking to build your credit with responsible use, explore cards for people with fair credit.
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Earn unlimited 1.5% cash back on every purchase, every day, with a cash back rewards card.
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Monitor your credit report and score with CreditWise from Capital One. It’s free, and using it won’t hurt your credit.