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How Lines of Credit Work


Types of Lines of Credit
A series of upcoming medical costs might be a good reason to apply for a line of credit.
A series of upcoming medical costs might be a good reason to apply for a line of credit.
Lenny Fuhrman/Getty Images

Two main types of lines of credit are available to money-seekers: the personal line of credit and the business line of credit. With both types, the financial institution that provides your line of credit will set a limit on the credit, similar to a credit card limit. Personal lines of credit are secured by the person's property. Personal property, such as a house, is the collateral that the lender can seize if the individual fails to pay back the loan.

The most common line of credit, and therefore the best example of how lines of credit work, is the home equity line of credit (HELOC). When you get a HELOC from your mortgage lender or other financial institution, you have a set period of time during which you can draw on the line of credit. This period is aptly named the draw term. During this term, you use checks, a special credit card or another method to use the money in your line of credit. Since HELOCs are long-term lending agreements, draw terms tend to be around 10 years.

During the draw term, interest will accrue at a rate determined by the line of credit's interest rate. Most lines of credit have a variable interest rate based on the prime rate plus a margin. For example, you might see a home equity line of credit offered at the prime rate plus percent or 2 points. The interest rate for the line of credit will always be 2 percent above the prime rate. When the prime rate changes, so does your interest rate.

How you make payments on your HELOC depends on the financial institution's offer. You might make monthly payments that go toward paying off both interest and principal. Or you might make payments only on the interest. In the latter situation, you would have to pay back the principal (the total amount you borrowed) at the end of the draw term. Alternatively, your lender might set up a repayment plan at the end of the draw term, which would allow you to pay back the principal in installments.

In principle, business lines of credit do not differ much from personal lines of credit. Like a HELOC, a business line of credit can also be an equity line of credit, which means the credit is based on your ownership interest in something. Instead of using personal property for collateral, however, a business line of credit is secured by your business's assets. These assets might be business real estate, company vehicles or even office furniture.

Just like a person may use a line of credit to pay for something big, like tuition at a private school, a business may use a line of credit to pay for a large cost, such as an expansion into the building next door or a company-wide software upgrade.

Next we'll look at the factors that affect your application for a line of credit.

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