What is a line of credit? Different types and how they work
A line of credit (LOC) is any type of loan that allows you to borrow against a preset limit. Payments and interest vary based on how much you borrow.
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 LOCs.
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LOCs can be unsecured or secured, depending on whether collateral is required.
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Examples include personal lines of credit (PLOCs), home equity lines of credit (HELOCs) and business LOCs.
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As with many loans, approval decisions for LOCs are typically based on creditworthiness.
How does a line of credit work?
Most LOCs are revolving accounts. Payments and interest payments vary based on the type of LOC, interest rates, balances and other terms. Depending on the type, some lenders charge origination fees, transaction fees and more.
LOCs are typically approved based on creditworthiness, which comprises factors such as credit history, income and debt. Lenders assign limits, interest rates and repayment terms based on the loan and the borrower.
Secured vs. unsecured LOCs
LOCs can be secured or unsecured accounts.
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Secured: 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.
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Unsecured: 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.
Common types of lines of credit and their requirements
Three common LOCs are personal, home equity and business. Here’s a quick look at their different purposes and borrowing requirements:
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.
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.
Business lines of credit
Business LOCs can be used by organizations to cover their operating costs and other business-related expenses. Depending on the agreement, a business LOC could be secured or unsecured. Collateral for an unsecured business LOC could include:
- Property
- Equipment
- Inventory
- Investments
Pros and cons of a line of credit
As with any kind of loan or credit, an LOC has some potential advantages and disadvantages.
Benefits
Possible benefits of an LOC include:
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Flexibility: LOCs let you borrow when you need it, up to a preset limit. And you only pay interest on what you borrow.
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Low interest rates: LOCs typically come with relatively low interest rates.
Downsides
LOCs may also have potential negative aspects to consider, including:
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Eligibility requirements: Borrowers with lower credit scores may find it difficult to qualify for an LOC.
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Fees: Lenders may charge origination or maintenance fees. And some LOCs come with transaction fees. This means that each time you borrow, you pay an additional fee for the transaction.
Line of credit vs. credit card: What’s the difference?
LOCs and credit cards are both ways to borrow money. Here’s a quick comparison:
| Line of credit | Credit card | |
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Borrowing window |
Most LOCs are revolving accounts, meaning you can borrow, repay and borrow again as long as you stay under the borrowing limit | 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 |
Does an LOC affect your credit scores?
According to FICO, applying for, opening and using credit like an LOC 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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Amounts owed
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Length of credit history
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Credit mix
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New credit applications
Line of credit FAQ
Want to learn more about LOCs? Here are answers to a few frequently asked questions:
What are some LOC examples?
Some LOC examples are a home equity line of credit, a personal line of credit and a business line of credit. They can be used to fund things like a home renovation, a vacation, a wedding, an unforeseen emergency or business expenses.
How do you get an LOC?
Banks, credit unions and others offer LOCs. 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. The higher your credit scores, the more likely you may be to get an LOC with lower interest rates.
How do you pay back an LOC?
LOCs 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
An LOC is one way to cover large or unexpected expenses. 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 if you’ll be approved with 100% certainty for a credit card 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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Monitor your credit report and score with CreditWise from Capital One. It’s free, and using it won’t hurt your credit score.
