Line of Credit: A Guide
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?
- Lines of credit often function similarly to credit cards.
- Lines of credit are often a type of revolving credit.
- Lines of credit may be unsecured or secured debt, 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. It may be offered by banks, credit unions or other financial institutions.
Revolving credit accounts, like lines of credit, are open ended. That means they don’t have a defined payoff date. If the line of credit remains open and in good standing, the borrower can continue to use it.
How Does a Line of Credit Work?
Lines of credit work differently depending on the type. They could be revolving or nonrevolving. On top of that, the line of credit could be secured or unsecured.
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. It functions in a similar way 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 don’t function like credit cards. 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, depending on the type.
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 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 (APRs). 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
Personal Line of Credit
A personal line of credit is typically an unsecured, revolving loan used for personal use. A personal line of credit might be used in similar ways to a credit card, like handing bills and other expenses.
Home Equity Line of Credit
Home equity lines of credit (HELOCs) are another common type of secured credit. Essentially, a borrower draws money against the equity they have in their home.
Business Line of Credit
Business lines of credit, like the name implies, 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 or inventory, or investments.
How a Line of Credit Affects Your Credit Scores
Applying, opening and using a line of credit can affect your credit scores in a number of ways. Here a few major factors involved in credit scoring:
- Payment history
- Credit age
- Credit mix
- New credit applications
How exactly it affects your scores depends on the credit-scoring model, the company doing the scoring and when your scores are calculated.
Lines of Credit In a Nutshell
Lines of credit may be unsecured or secured debt, 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 for a Capital One card with no impact to your credit.
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