What is a line of credit? Different types and how they work
A line of credit (LOC) is a type of loan. Borrowers draw from a fixed amount of money and repay what they’ve borrowed again and again, sometimes over a fixed time frame. Some credit lines are for personal use, while others are for business expenses. Interest and loan terms depend on how the credit line is structured.
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.
- Like with many loans, approval decisions for lines of credit are typically based on creditworthiness.
How does a line of credit work?
Generally, a line of credit has a set credit limit, or a cap on the funds available to you. Usually, 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 can have either fixed or variable interest rates. And they might 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 called 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.
Line of credit vs. credit card: What’s the difference?
Lines of credit and credit cards are both ways to borrow money. How the two borrowing methods are structured and used sets them apart. Here’s a general comparison:
| Line of Credit | Credit Card | |
| Borrowing window | Dependent on whether the line is revolving or not | Remains open with no set end date as long as the account is in good standing |
| Methods of borrowing | Lump sum payments or accessed with special checks or cards | Physical credit card or digital options |
3 types of lines of credit and their requirements
Here are three common types of credit lines, plus requirements that 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 by lender. And to approve a PLOC, lenders might require a strong credit history and an open checking account with the same financial institution.
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, which is a type of second mortgage, lenders typically request an appraisal to assess the home’s value. From there, the lender will determine the credit limit, which is usually a percentage 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, but 10 years is a common time frame. During the draw period, they can access and repay funds again and again as long as purchases stay within the limit.
After the draw period, there’s typically a repayment period. This is when a borrower pays the outstanding balance according to the loan terms.
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, a business line of credit 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, a line of credit has some potential benefits and negative impacts.
4 line of credit benefits
Some possible upsides of a line of credit 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
- Overdraft protection
4 potential downsides to a line of credit
Lines of credit may also have potential negative impacts to consider, including:
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Borrowers with low credit scores may have a difficult time qualifying for some lines of credit.
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There may be fees for origination, transactions and more.
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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 few frequently asked questions:
When would someone use a line of credit?
Reasons to take out a line of credit vary depending on each individual and their situation. Some borrowers might apply for lines of credit when they don’t know exactly how much money they’ll need or when they’ll need it.
For instance, if you’re renovating your home, a line of credit could help you fund the project. A line of credit may also help with unforeseen emergencies or business expenses.
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 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: Line of credit
A line of credit is one way to cover large or unexpected expenses. Before taking out a line of credit, it can help to look into fees, interest and how it could impact your finances and credit scores.
Credit cards are another way to get convenient, flexible access to funds. If you’re new to credit or searching for your next credit card, Capital One can help:
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See whether 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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