Lines of credit are agreements between financial institutions and borrowers that set a maximum loan balance that can be drawn upon at any time. They are commonly used by businesses to smooth out cash flow and handle payroll. Interest is usually not charged on the unused line of credit, making this a cost-effective method of cash management.
Lines of credit are available to individuals as well as businesses – you may already have access to one and not realize it. Overdraft protection for checking accounts is in essence a line of credit.
Personal lines of credit (PLCs) fill a gap between large, single-purpose loans such as a mortgage or auto loan, and standard revolving credit such as credit cards. As such, the interest rates are typically between those of traditional loans and credit cards. They are useful for events with large deposits and/or variable costs such as weddings, home remodeling, and uncovered medical expenses; or for people with regular expenses but large variations or delays in income, such as the self-employed or those paid by large commissions.
PLCs may be unsecured, or secured with collateral. Unsecured lines of credit carry higher risk, and therefore higher rates. A typical value of PLC is $10,000 or below, but they can be significantly larger or smaller.
- Secured PLC – The most popular form of the secured PLC is the home equity line of credit (HELOC). This is different from a home equity loan – a HELOC allows you to borrow only as much as you need throughout a given period of time, and only when you need it. They are similar to a loan in that there is a set time period, typically ten years, where you can withdraw money (known as the draw period). Repayments vary; examples are monthly on interest and principal, interest-only with principal payment at the end, and an installment plan after the draw period.
Interest rates on a HELOC are variable, usually at 2% over the prime rate. Your limit is determined by a percentage of the value of your house minus the amount you owe. For example, if a bank offers a 75% HELOC on your $400,000 house and you still owe $250,000, you qualify for a $50,000 HELOC ($400,000 x 75% = $300,000; $300,000 – $250,000 = $50,000).
Banks may also offer secured PLC's against your savings account, certificates of deposit, or other assets that you hold with the bank. Terms will vary depending on the type of your collateral and history with the bank.
- Unsecured PLC – Most banks offer you unsecured PLC's if you do business with them in some other way. There may be fees, minimum amounts or usage/maintenance fees, other limitations – and the interest rate will be higher. They may be tied in with your overdraft protection for your checking account.
Usually, unsecured PLCs are more like a standard revolving credit card account with no fixed draw period. Check with your bank for details.
If you are a small business owner or independent contractor, a small business line of credit may make more sense for you, depending on how (or if) you are incorporated. Again, these may be unsecured or secured – in this case by your business assets – and are generally revolving accounts with interest rates determined by the creditworthiness of your business.
If you have large mismatching between income and expenses, whether temporary or permanent, and need better interest rates and greater flexibility than credit cards or loans can provide, a PLC may be the right choice for you. As with all forms of debt, use a business or personal credit line with care.
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