How Lines of Credit Work


People sometimes apply for lines of credit to finance a series of home improvements.
People sometimes apply for lines of credit to finance a series of home improvements.
Justin Sullivan/Getty Images

Are you planning on renovating your house over the next several years, but you don't know how much it will cost? Perhaps you foresee long-term medical costs that may not be completely covered by your insurance. Maybe your twin daughters surprised you by getting accepted to Ivy League schools, and you need to fill in the financial gap. A line of credit is one financial strategy to tackle large and unpredictable or variable costs.

A line of credit is a type of loan that doesn't give you one giant injection of funds the way a traditional loan does. Like a credit card, you draw on the credit when you need to pay for something that is financially out of reach. Unlike most credit cards, the interest rates on lines of credit are generally low, and the limits tend to be high.

There are several reason why a person may choose a line of credit over a traditional loan. With a traditional loan, you get a chunk of money and immediately begin paying the loan back, regardless of when you actually use the money. But a line of credit lets you borrow the amount you need when you need it. With most lines of credit, you make payments only on the credit you've actually used.

Let's explore the types of lines of credit and which factors decide whether or not you'll qualify for one.

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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Factors to Getting a Line of Credit

The prime interest rate charged by the U.S. Federal Reserve affects the interest rate you get on lines of credit and traditional loans.
The prime interest rate charged by the U.S. Federal Reserve affects the interest rate you get on lines of credit and traditional loans.
KAREN BLEIER/AFP/Getty Images

How much do you really know about your credit score and how it's calculated? Find out in our Credit Score Quiz.

Many factors come into play when you apply for a line of credit. As you probably know, your creditworthiness is expressed by your credit score, a number based on the size of your debt and how timely your debt payments have been in the past. The higher the score, the more likely a financial institution will extend you a line of credit.

When you apply for a line of credit, a lender also looks at your ability to repay and your credit history. It evaluates how much money you make, how secure and sustainable your job and lifestyle are and how you've paid your past debts. For business lines of credit, a financial institution evaluates profitability and business risk. It scrutinizes your business's profit/loss history, as well as any risks like a large investment in a new technology that could impact your ability to pay back the loan.

The HELOC serves as a good example of how your credit limit is determined. With a HELOC, the limit of your line of credit is based on a calculation involving the market value of your house. The financial institution determines your limit by subtracting what you owe on your mortgage from a percentage (usually 75 to 80 percent) of the market value of your house. Let's say an appraiser values your house at $500,000. You still owe $200,000 on your mortgage. A given bank offers you an 80-percent line of credit. Here's the calculation for your line of credit limit:

$500,000 x 80% = $400,000

You still owe $200,000, so

$400,000 - $200,000 = $200,000 credit limit

The financial institution may decrease this limit based on your credit history and ability to repay.

For a business line of credit, the financial institution determines your credit limit based on the value of the business assets you use to secure the line of credit. Your office building, or other business real estate, is the most likely candidate.

A financial institution determines the interest rate on your line of credit by adding an indexed percentage rate -- such as the prime rate or the lowest interest rate you could possibly get from the bank -- to a margin. This margin is affected by your credit history, ability to repay, profitability and business risk, as well as the bank's ability and willingness to take financial risks. Your variable interest rate will increase and decrease as the chosen index increases and decreases.

Again, a line of credit is useful for people or businesses that face several large costs over several years, but there are alternatives to lines of credit. A home equity loan may finance a single large project, such as finishing the attic so that the in-laws can move in. The high interest rates of credit cards tend to be dangerous for large purchases that can't be repaid quickly. But if you need to make a series of small purchases and can pay back the money fairly quickly, a credit card might be a better choice than a line of credit.

If you'd like to know more about lines of credit and related topics, you can follow the links on the next page.

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Sources:

  • AllBusiness. "How Do Lines of Credit Work?" http://www.allbusiness.com/business-finance/business-loans-business-credit/902-1.html (Accessed 5/5/08)
  • AllBusiness. "Understanding Business Lines of Credit." http://www.allbusiness.com/business-finance/business-loans-business-credit/11195-2.html. (Accessed 5/5/08)
  • FDIC. "Coming Soon: Free Credit Reports and Access to Credit Scores." Fall 2004. http://www.fdic.gov/CONSUMERS/consumer/news/cnfall04/soon.html (Accessed 5/6/08)
  • Federal Reserve Board. "What you should know about home equity lines of credit." 6/12/07. http://www.federalreserve.gov/Pubs/equity/equity_english.htm (Accessed 5/5/08)
  • Investopedia. "Credit Score." http://www.investopedia.com/terms/c/credit_score.asp (Accessed 5/6/08)
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  • Whittle, Adrian. "How Does A Home Equity Line Of Credit Work." Ezine Articles. 7/26/07. http://ezinearticles.com/?How-Does-A-Home-Equity-Line-Of-Credit-Work&id=662575 (Accessed 5/5/08)