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What Is a Line of Credit & How Does It Work?

Sometimes when a person needs money, they borrow from friends, open a new credit card, seek out a payday loan, or request a traditional loan from a bank with a fixed interest rate. These options aren’t always available or the right fit, so you may seek an alternative. 

A line of credit is a quick and easy way to expand your financial access when faced with emergency repairs, the need to manage cash flow, to fund a project, or if you are in a tight squeeze. 

What Is a Line of Credit?

Perhaps you may be thinking, “what is a line of credit?” 

A line of credit is an unsecured, flexible loan from a credit union or bank that is “on-demand” and does not require any collateral. A person or a business may open a line of credit to access money whenever needed. 

The terms for this form of credit often vary from lender to lender, and approval may depend on the length of the relationship between you and your lender. Your credit rating also plays a large role in acceptance.

How Does a Line of Credit Work?

After your line of credit application is approved, you will have a set time frame where you can withdraw funds. The draw time can vary and is dependent on terms agreed by you and your lender. 

Interest begins to charge as soon as the loan is borrowed. It is common for a line of credit to have a variable interest rate. A variable interest rate loan means that interest charged on an outstanding balance can fluctuate because it is based on an underlying benchmark rate that changes frequently. 

As a result, your payments will vary as well. This can make it difficult to calculate or determine the amount of money you will actually end up paying back. 

How Do I Repay a Loan From My Line of Credit?

To repay your loan, you will receive a bill that resembles a credit card bill. It will highlight your advances, payments, interest, and any fees associated with the loan. A minimum payment will be due within your bill, but you may always pay extra to save on interest over time.

Keep in mind that the pool of available credit you qualify for will not replenish after making payments towards the principal. And once you pay off your line of credit, your account will close and cannot be used again. This means you will need to open a new line of credit each time you need to access funds this way. 

What Are the Benefits of a Line of Credit?

Opening a line of credit is useful when making a purchase that a credit union or bank doesn’t typically underwrite a loan for. These purchases could be home improvements, vacations, paying for a wedding, or debt consolidation.

It is also a great option for workers in the side gig economy like freelancers or self-employed folks who experience irregular payments between completing work and collecting payment. Having a line of credit acts as a cushion for funds to hold you over. Most terms for lines of credit are cheaper than payday loans which can be shady and risky at best.

What Are the Risks of a Line of Credit?

With any financial decision, there are risks involved. For instance, would-be borrowers with insufficient credit may face difficulties like higher interest rates or could be unable to secure a line of credit. When your lender pulls your credit, it is considered a “hard inquiry,” and your credit score may drop a few points. 

If using a line of credit to pad income, the interest charged is not tax-deductible, which leaves you responsible for the entire cost. In some cases, your lender may charge a maintenance fee if you do not utilize a line of credit after opening it.  

Another factor to consider is if you are only making minimum payments on your loan, be aware if there is a clause within your agreement that you must pay off funds borrowed before a set date. This could cause you to pay a large “balloon” payment that may be difficult to manage at the end of your loan term.  

Ready to Get a Line of Credit?

If you’re ready to look into getting a line of credit, you’re in the right place! Now that you know a bit about what a line of credit is and how it works, you can take the next steps towards applying. 

Click below to learn more!  

How to Get a Line of Credit