What Is a Line of Credit?
A line of credit is kind of like a credit card. You have a set amount you can borrow, and interest doesn't begin to accrue until you start using the credit. And when you pay back the loan, your credit line is renewed.
But before you decide to open a line of credit, read on and learn the basics so you can get a feel for whether or not this is the best option for you.
Up ahead:
-- What credit score do you need to get a line of credit?
-- When does it make sense to use a line of credit?
-- How to apply for a line of credit.
What Is a Line of Credit?
A line of credit is a preset amount of money that you've been approved to borrow from a bank, credit union or other financial institution. You can borrow as little or as much as you need, up to the maximum amount offered. You will be charged interest on the amount borrowed until you've repaid the balance.
Sometimes, it's easier to describe how a money move works with real-life examples, so let's take a look at a situation where a line of credit is often considered.
Line of Credit Examples
There are secured and unsecured lines of credit. With a secured line of credit, you're putting up collateral to secure the loan. Let's say you decide to apply for a home equity line of credit.
The collateral -- or security -- is the equity in your house. With a secured line of credit, the interest rates can be pretty good since it's less risky for the lender. But the downside is a big one: If you don't pay it back as agreed, the lender can take your home.
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In contrast, a personal line of credit is unsecured, which means there's no collateral. And since there's no collateral, it's riskier for the lender. This means the interest rates for your unsecured line of credit will be a bit higher than they would be for a secured line of credit.
Here's an example of an unsecured line of credit: You want to remodel your home, but you don't know how much it will cost. So you apply for a line of credit from your bank, which allows you to draw on the money as you need it during your renovations. To your delight, you've been approved for a $20,000 line of credit from your bank.
After a month or so, you've used $15,000 on the remodeling project. Your line of credit is now $5,000. But you are now paying interest on the money borrowed, so make at least minimum monthly payments. As you repay your balance, your credit line increases by that amount repaid.
The details differ among institutions, but you usually have a set period of time to access your line of credit. When the draw period ends, you continue to work on repaying the money borrowed.
If you want to apply for an unsecured personal line of credit, you first need to estimate how much money you might need to complete your project or pay off your debt. You can then start researching your options.
But before you apply for a line of credit, you need to make sure your credit is in a good place.
What Credit Score Do You Need to Get a Line of Credit?
Since a personal line of credit is unsecured, you'll need good or great credit to get approved. So, before you apply, check your free annual credit reports and your credit score to see where you stand.
You'll need a prime credit score to get the best rates. I've seen what's considered a prime score fluctuate over the years, but here are the ranges according to the Consumer Financial Protection Bureau:
-- Deep subprime: Credit scores below 580.
-- Subprime: 580-619.
-- Near-prime: 620-659.
-- Prime: 660-719.
-- Super-prime: 720 or above.
As you can see, a near-prime score starts in the mid-to-high 600s, but if you're in that category, it's more difficult to get approved for a line of credit.
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Now, keep in mind that a line of credit is considered a revolving account, like your credit cards. If you use too much of your credit line or get sloppy with payments, it could decrease your credit score. Set up reminders or automatic payments so you don't forget to make a monthly payment.
When Does It Make Sense to Use a Line of Credit?
One of the biggest advantages of a line of credit is getting funds quickly. And if you have great credit, you'll get a good interest rate. Handle your line of credit responsibly and it could increase your credit score.
But the opposite can happen if you aren't careful. I've seen people get in over their heads with a credit line when they used it for the wrong reasons.
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For example, don't start thinking of this as your personal emergency fund. In fact, if you don't have an emergency fund with at least six months' worth of expenses, then postpone any home improvement projects on your list and get your rainy-day fund in good shape.
If you're using a line of credit to pay off credit card debt, think about a balance transfer credit card first. A consumer with a super-prime credit score (720-plus) will most likely qualify for a 0% annual percentage rate introductory offer on a balance transfer credit card. There's often a 3% to 5% fee associated with balance transfer cards, so add that to the total you'd have to pay off on a balance transfer credit card.
Decide what your monthly payment needs to be (amount transferred plus any fee applied) to pay it off -- or at least way down -- during the intro period. Most balance transfer 0% APR offers range from 12 to 21 months. It's a great opportunity to get rid of your debt while paying no interest during the intro period.
How to Apply for a Line of Credit
Every institution has its own rates and guidelines. You can check with your bank to see if a line of credit is available. But even if it is, I recommend researching other options online and comparing rates. On many websites, you can get a preview of what your rate and payments might be. Also look for any fees that are involved. For instance, most credit lines come with an annual fee.
After you research your options and choose a bank or credit union for a line of credit, be prepared to provide some or all of the following: home address, employer information, income, tax returns, bank statements and other pertinent financial information.
Response times are usually pretty quick, so if you're approved, you won't have to wait long for access to the funds.