Understanding Lines of Credit (LOC): Definition, Types & Examples
What Is a Line of Credit (LOC)?
A line of credit (LOC) is an amount of money available for borrowing with the maximum borrowing limit set by the lender. Banks and financial institutions offer LOCs to their personal and business customers. LOCs are a flexible funding source because they can be accessed at any time and no interest is charge except on borrowed funds. As money is repaid, it can be borrowed again. Lenders base the borrowing limit they set on the borrower’s creditworthiness.
Key Takeaways
- A line of credit (LOC) provides flexible borrowing options, allowing users to access funds up to a set limit and repay as needed, only incurring interest on the borrowed amount.
- There are various types of LOCs, including personal, business, and home equity lines of credit (HELOCs), each with unique features suited to different needs.
- Secured LOCs, like HELOCs, typically offer lower interest rates due to collateral requirements, while unsecured LOCs have higher rates and stricter credit qualifications.
- The ability to revolve credit makes LOCs advantageous for ongoing funding needs, whereas non-revolving lines of credit do not replenish after repayment.
- Excessive use of a line of credit can adversely affect credit scores, especially if usage exceeds 30% of the borrowing limit.
Investopedia / Julie Bang
How Do Lines of Credit (LOCs) Work?
A line of credit is a financial product that banks offer to both individuals and businesses. Customers must qualify for the LOC and be approved. The borrowing limit depends on the borrower’s creditworthiness.
LOCs let you borrow, repay, and borrow again up to a set amount. The lender sets interest rates and payment sizes. You may write checks or use a debit card for access. Secured LOCs have lower rates due to collateral, while unsecured ones have higher rates.
The flexibility of an LOC is its main benefit. Borrowers can use only what they need and pay interest only on that amount. They can adjust repayments based on their budget, repaying fully or just the minimum.
There are different types of LOCs that financial institutions offer. Some of the most common types of LOCs include personal, business, and home equity lines of credit (HELOCs). We explore these in more detail below.
Comparing Unsecured and Secured Lines of Credit
Most LOCs are unsecured loans. This means that the borrower does not promise the lender any collateral to back the LOC. One notable exception is a home equity line of credit (HELOC), which is secured by the equity in the borrower’s home. From the lender’s perspective, secured LOCs are attractive because they provide a way to recoup the advanced funds in the event of nonpayment.
Secured LOCs are appealing because they offer higher limits and lower interest rates. In contrast, unsecured LOCs require higher credit scores and are harder to obtain.
Lenders attempt to compensate for the increased risk by limiting how much can be borrowed and by charging higher interest rates. That is one reason why the annual percentage rate (APR) on credit cards is so high.
Credit cards are technically unsecured LOCs, with the credit limit—how much you can charge on the card—representing its parameters. But you do not pledge any assets when you open the card. If you start missing payments, there’s nothing that the credit card issuer can seize in compensation.
Important
An LOC can affect your credit score; using over 30% of your line can lower it.
Distinguishing Revolving and Non-Revolving Lines of Credit
An LOC is often considered to be a type of revolving account, also known as an open-end credit account. This arrangement allows borrowers to spend the money, repay it, and spend it again in a virtually never-ending, revolving cycle. Revolving accounts such as LOCs and credit cards are different from installment loans such as mortgages and car loans.
With installment loans, you borrow a fixed amount and pay it back monthly. After repayment, you must apply again to borrow more.
Non-revolving LOCs have the same features as revolving credit (or a revolving LOC). A credit limit is established, funds can be used for a variety of purposes, interest is charged normally, and payments may be made at any time. There is one major exception: The pool of available credit does not replenish after payments are made. Once you pay off the LOC in full, the account is closed and cannot be used again.
As an example, personal LOCs are sometimes offered by banks in the form of an overdraft protection plan. A banking customer can sign up to have an overdraft plan linked to their checking account. If the customer goes over the amount available in checking, the overdraft keeps them from bouncing a check or having a purchase denied. Like any LOC, an overdraft must be paid back, with interest.
Exploring Different Types of Lines of Credit
LOCs come in a variety of forms, with each falling into either the secured or unsecured category. Beyond that, each type of LOC has its own characteristics.
Personal Line of Credit (LOC)
This provides access to unsecured funds that can be borrowed, repaid, and borrowed again. Opening a personal LOC usually requires a credit history of no defaults, a credit score of 670 or higher, and reliable income.
Having savings helps, as does collateral in the form of stocks or certificates of deposit (CDs), though collateral is not required for a personal LOC. Personal LOCs are used for emergencies, weddings, overdraft protection, travel, and entertainment, and to help smooth out bumps for those with irregular income.
Home Equity Line of Credit (HELOC)
HELOCs are the most common type of secured LOC. A HELOC is secured by the market value of the home minus the amount owed, which becomes the basis for determining the size of the LOC. Typically, the credit limit is equal to 75% or 80% of the market value of the home, minus the balance owed on the mortgage.
HELOCs often come with a draw period (usually 10 years) during which the borrower can access available funds, repay them, and borrow again. After the draw period, the balance is due, or a loan is extended to pay off the balance over time. HELOCs typically have closing costs, including the cost of an appraisal on the property used as collateral.
Fast Fact
Since the Tax Cuts and Jobs Act (TCJA) of 2017, interest paid on a HELOC is only deductible if the funds are used to “buy, build or substantially improve” the property that serves as collateral for the HELOC.
Business Line of Credit
Businesses use these to borrow on an as-needed basis instead of taking out a fixed loan. The financial institution extending the LOC evaluates the market value, profitability, and risk taken on by the business and extends an LOC based on that evaluation. The LOC may be unsecured or secured, depending on the size of the LOC requested and the evaluation results. As with almost all LOCs, the interest rate is variable.
Demand Line of Credit (LOC)
This type can be either secured or unsecured but is rarely used. With a demand LOC, the lender can call the amount borrowed due at any time. Payback (until the loan is called) can be interest only or interest plus principal, depending on the terms of the LOC. The borrower can spend up to the credit limit at any time.
Securities-Backed Line of Credit (SBLOC)
This is a special secured-demand LOC, in which collateral is provided by the borrower’s securities. Typically, an SBLOC lets the investor borrow anywhere from 50% to 95% of the value of assets in their account. SBLOCs are non-purpose loans, meaning that the borrower may not use the money to buy or trade securities. Almost any other type of expenditure is allowed.
SBLOCs require the borrower to make monthly, interest-only payments until the loan is repaid in full or the brokerage or bank demands payment, which can happen if the value of the investor’s portfolio falls below the level of the LOC.
Limitations of Lines of Credit (LOC)
The main advantage of an LOC is the ability to borrow only the amount needed and avoid paying interest on a large loan. That said, borrowers need to be aware of potential problems when taking out an LOC.
- Unsecured LOCs have higher interest rates and credit requirements than those secured by collateral.
- Interest rates for LOCs are almost always variable and vary widely from one lender to another.
- LOCs do not provide the same regulatory protection as credit cards. Penalties for late payments and going over the LOC limit can be severe.
- An open LOC can invite overspending, leading to an inability to make payments.
- Misuse of an LOC can hurt a borrower’s credit score. Depending on the severity, the services of a top credit repair company might be worth considering.
What Are Common Types of Lines of Credit?
The most common types of lines of credit are personal, business, and home equity. In general, personal LOCs are typically unsecured, while business LOCs can be secured or unsecured. HELOCs are secured and backed by the market value of your home.
How Can I Use a Line of Credit?
You can use an LOC for many purposes. Examples include paying for a wedding, a vacation, or an unexpected financial emergency.
How Does an LOC Affect My Credit Score?
Lenders conduct a credit check when you apply for an LOC. This results in a hard inquiry on your credit report, which lowers your credit score in the short term. Your credit score will also drop if you tap into more than 30% of the borrowing limit.
The Bottom Line
A line of credit is a flexible and attractive credit tool because it allows a borrower to draw funds as needed. They can borrow as often as they need to, as long as they replenish their LOC by repaying outstanding amounts. The limit on their borrowing set by the lender is based on their credit and keeps their spending within an acceptable realm. Personal, business, and home equity lines are LOCs designed to meet the financial needs of individuals and companies. Potential risks of a line of credit include high interest rates charged, overspending, and the impact on one’s credit score if the LOC is used excessively.
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