Lines of credit: Definition, types and examples
June 27, 2023 5 min read
A line of credit is a type of loan that functions similarly to a credit card, allowing people to withdraw and repay money over and over again for as long as the account remains open and in good standing.
But how does a line of credit work? And in what situations might a line of credit be useful? Use this guide to learn more.
- Lines of credit usually work similarly to credit cards.
- Lines of credit are often a type of revolving credit.
- Lines of credit may be unsecured or secured, depending on whether collateral is required.
- The application process for a line of credit is similar to that of other loans, and approvals are based on creditworthiness.
What is a line of credit?
A line of credit is typically a type of revolving loan where you can get access to a specific amount of money and continue to use it as needed—as long as the account remains open and in good standing. That’s because revolving credit accounts, like lines of credit, are open-ended. That means they don’t have a defined payoff date.
Lines of credit may be offered by banks, credit unions or other financial institutions. And most come with a variable interest rate—meaning the rate can fluctuate within the terms of the loan agreement.
How to use a line of credit
Lines of credit are usually used in situations where the borrower needs to cover an unexpected expense or is unsure of the total amount of money they’ll need for something.
How does a line of credit work?
Lines of credit are revolving accounts. But there are exceptions that can affect how a line of credit works.
Revolving line of credit vs. nonrevolving line of credit
With a revolving line of credit, you can make repayments and reborrow money over and over again as long as you don’t exceed the maximum limit. In this way, it functions similarly to a credit card. As the line of credit is used, the amount of available credit goes down. As it’s paid back, the available credit goes back up.
Nonrevolving lines of credit are similar to revolving lines in the sense that there are funds available to the borrower. But these lines of credit don’t function like credit cards. The difference is that once money is used and paid back, nonrevolving accounts are typically closed and can no longer be used.
Secured line of credit vs. unsecured line of credit
Lines of credit may be secured or unsecured.
With a secured line of credit, a borrower provides collateral. If they don’t repay the funds, the lender can take the assets used as collateral.
Because there’s no collateral with unsecured lines of credit, they may have higher interest rates than secured lines of credit.
How does a line of credit application work?
If you apply for a line of credit, the process may be similar to that of other loans or credit applications. Lenders generally review an applicant’s creditworthiness to determine whether they’re eligible. Borrowers with higher credit scores are more likely to get a line of credit and be offered lower interest rates.
Borrowers can then weigh different options by comparing things like annual percentage rates. A borrower can also look for fees and other costs related to opening the account.
If approved, borrowers may be able to access their line of credit using a card or a checkbook.
Common lines of credit and their requirements
You may be wondering, “What are the requirements for a line of credit?” Here are common lines of credit and their requirements:
Personal line of credit
A personal line of credit (PLOC) is typically an unsecured, revolving loan that’s taken out for personal use. A PLOC might be used in similar ways to a credit card, like handling bills and other expenses. Terms for a PLOC vary, depending on the lender, but the Consumer Financial Protection Bureau says banks and credit unions “often require strong creditworthiness for approval.” And borrowers might also be required to have a checking account with the lender.
Home equity line of credit
Home equity lines of credit (HELOCs) are another common type of secured credit. With this type, a borrower can 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 is usually 75% to 80% of the home’s market value.
If you’re approved for a HELOC, you can draw against your 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, funds can be accessed and repaid over and over again—as long as purchases stay within the limit.
Business line of credit
Business lines of credit can be used by organizations to cover costs related to running a business. Depending on the agreement, they could be unsecured or secured. In the case of secured business lines of credit, collateral could take the form of assets such as property, equipment, inventory or investments.
How 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 a few major factors involved in credit scoring:
How exactly it affects your scores depends on the credit-scoring model, the company doing the scoring and when your scores are calculated.
Is it worth getting a line of credit?
Lines of credit are one way to help cover a major or unexpected expense like funding a wedding or home renovation. But whether a line of credit is a good option comes down to individual circumstances. As with any loan, before applying, it helps to make sure you fully understand its terms and have an understanding of how it might fit into your budget.
Lines of credit in a nutshell
Lines of credit may be unsecured or secured, depending on whether collateral is required.
Similar to a line of credit, a credit card can offer flexible access to funds. And some credit cards can also offer some advantages over a line of credit, like cash back or miles rewards. Learn more about Capital One cards or see if you’re pre-approved with no impact to your credit.