What is A Line of Credit?
Definition: A line of credit (LOC) is a preset amount of money that a financial institution agrees to lend.
Similarly, it is an arrangement that establishes the maximum amount of money that the customer can borrow. In this case, a borrower can take money as a loan, repayable after some time up to a given limit.
Line of Credit Examples
All lines of credit come with a set amount up to which a borrower can withdraw as needed. Financial institutions set the amount of interest that customers have to pay on any withdrawn money from a line of credit.
While borrowers can request any amount from the line of credit, they do not have to use the whole amount. By limiting withdraws, customers can essentially reduce the amount of money they owe interest on. While some lines of credit allow customers to use checks or drafts, others include debit and credit card provisions.
When it comes to paying back any amount used in a line of credit, customer don’t have to repay the entire amount at a go. Instead, one can spread the payments depending on budget or cash flow.
Secured vs. Unsecured LOC
A line of credit can be secured or unsecured. Unsecured line of credits don’t require customers to offer collateral to receive a given amount as part of a line of credit. Such loans are typically risky for financial institutions, as they do not provide a provision for recouping any used amount upon a customer defaulting on payments.
One of the major drawbacks of the unsecured line of credit is that they come with higher interest compared to secured LOC’s. Similarly, given the lack of collateral, a financial institution might be reluctant to issue a preferred line of credit. Unsecured LOC are also difficult to obtain, as they require a higher credit score. Credit cards are a perfect example of unsecured LOC
A secured line of credit, on the other hand, requires customers to place collateral whose value can cover a given line of credit. Secured lines of credits are attractive to lenders as they provide leeway for recouping advanced payment, in instances where borrowers struggle to repay back any amount used.
Secured line of credits are also attractive to businessmen as they come with a higher maximum credit limit and lower interest rate depending on the value of the collateral in use.
Revocable Line of Credit
A revocable Line of Credit is a special type of LOC that a financial institution can revoke at any given time or under certain circumstances. These types of LOC allow financial institutions to cancel an agreement with an individual or business should their financial position deteriorate or market condition warrant cancellation.
Cancelation of a line of credit was common at the peak of the 2008 financial crisis, as financial institutions came to terms with worsening market conditions.
Line of Credit Pros and Cons
Benefits
A line of credit can be cheaper as opposed to using a credit card. The interest rates on offer are usually low, especially when dealing with secured LOC. Some credit cards, on the other hand, come with APR of as much as 29%.
The fact that line of credit cards are usually linked to banking accounts reduces the temptation of impulse buying, as is the case with credit cards.
Line of credits is highly convenient as they can be processed in under 24 hours. In contrast, it might take up to two weeks to have credit card processed.
An unsecured line of credit card could come in handy for people who don’t have collateral to offer, in order to get a loan.
Drawbacks
Some lines of credit come with higher interest rates compared to other types of credit available in the market. In some instances, they may come with higher interest rates compared to the home equity line or secured credit line.
Another drawback of LOC is that it can be difficult to get an increase in an LOC once the allocated funds are exhausted.