What Is Line of Credit(LoC)?
A loan with a pre-determined borrowing limit that can be used at any time. You can draw from the credit line as needed, up to its credit limit, repay the borrowed money to replenish the credit line, and borrow from it again.
All LoCs have a preset amount that can be borrowed as needed, repaid, and then borrowed again. The credit limit, interest rate, the repayment amount, and other terms are set by the lender (bank, fintech lending platform, NBFCs, etc.).
The best feature of a credit line is its built-in flexibility. You can request a certain amount, but you can decide not to use the entire amount. Rather, you can tailor your withdrawals according to your needs and pay interest only on the amount you withdraw, not on the entire approved credit limit.
You can also choose the repayment amounts based on your budget and cash flow situation. You can even decide to pay the entire outstanding in one go or split it into monthly installments.
There are various types of credit lines. Let’s take a look:
Unsecured vs. Secured Credit Lines
Most credit lines are unsecured loans. This means you do not have to pledge collateral. However, secured credit lines are also available.
Unsecured LoCs, because it is not backed by collateral (increased risk for the lenders) have higher interest rates and lower credit limits. An example of an unsecured LoC is a credit card, which has a high-interest rate. If you miss payments on your credit card, there are serious consequences like late fees and adverse impact on your credit score, but your credit card provider cannot seize your assets in compensation.
On the other hand, a secured LoCs are backed by collateral (less risk for the lenders) have a higher credit limit and lower interest rate. An example of a secured credit line is the home equity line of credit (HELOC) secured by the equity in the borrower’s home. If you miss payments on a secured credit line, the lender can seize your assets.
Revolving vs. Non-Revolving LoCs
A revolving credit is an open-end credit account. This arrangement allows you to borrow when needed, repay and reuse. Thus creating a virtually never-ending, revolving cycle.
A non-revolving LoC has the same features as a revolving credit line – a pre-determined credit limit that allows you to borrow as and when needed and repays the borrowed amount. However, there is one exception. The repayments do not replenish the credit line. Once the outstanding is paid off the account is closed, never to be used again.
Each type of credit line falls either in a secured or unsecured category, but beyond that, it has its own characteristics. Here are a few examples:
A personal LoC is an unsecured revolving credit account. You need to have a good credit score and a reliable income to set up a personal credit line. These credit lines are best for use in emergencies, weddings, home renovations projects, travel, and filling the financial gaps due to irregular income.
Home Equity LoC (HELOC)
HELOCs are the most common type of secured LoC. A HELOC is secured by the market value of your home minus the amount owed. You can borrow as needed from the pre-approved credit line.
Instead of taking a fixed business loan, businesses often use secured business credit to borrow money on an as-needed basis. The financial lending institution offers a business credit after evaluating the profitability, market value, and potential risks of the business.