What is a Line of Credit And How Does It Work?

What is a Line of Credit?

A line of credit, also known as LOC, is a pool of money you can borrow from a bank or Non-Banking Financial Company (NBFC) when the need arises. Similar to a credit card, it comes with a pre-approved credit limit, and the borrower can use the credit limit as per his/her financial requirements. This credit line is generally an unsecured source of funds offered for personal as well as business needs. The borrower can use the line of credit facility and withdraw funds through bank transfer or line of credit cheques, as many times as often as he/she needs during the loan term.

Here are the features and benefits of a Line of Credit:

• LOC is a flexible loan option that allows you to withdraw money from an approved credit limit as and when required.

• The lender charges the interest only on the amount utilised and not on the entire credit limit.

• It is not mandatory to use the entire credit limit.

• Like any other type of loan, the used amount of the line of credit must be repaid by the borrower with interest as per the terms of the lender and repayment schedule.

• The repayment can be done at once or in minimum monthly repayments until the end of the tenure, which is generally up to 5 years.

• Based on the borrower's repayment history and credit profile, he/she can get the line of credit limit increased within his/her loan tenure.

• As discussed, there is no restriction on the end use of the usage of the money borrowed from the line of credit facility as far as it is used for a legitimate purpose. So, similar to personal loans, you are free to use the loan amount for any of your financial requirements, such as paying your child's school fees, renovating a house, starting a home-grown business, buying a bike, paying hospital bills, and many more.

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What are the types of Lines of Credit?

The lines of credits can have different types based on different categories.

1. Revolving vs Non-Revolving Line of Credit:

Generally, most lenders offer a revolving line of credit that allows borrowers to spend money from the available credit limit as and when required, repay it as per their convenience, and spend the available limit and repay it again before the end of the loan term. This makes the spend-repay cycle virtually never-ending, hence the name. A non-revolving line of credit allows borrowers to use and repay the available credit limit at their convenience in a similar manner, except that the repayment of the loan does not reopen the credit limit. Once you utilise the entire credit limit and repay it, the line of credit is closed.

2. Unsecured vs Secured Line of Credit:

As the name suggests, to avail of the secured line of credit, you have to pledge an asset. In case you fail to make the repayments on time or default on the loan, the lender can liquidate your asset (collateral) to cover the dues. On the contrary, an unsecured line of credit is offered after considering several factors, such as your credit score, repayment capacity, income, debt-to-income ratio, lender's lending policy, etc. Since lending unsecured lines of credit is comparatively riskier to the lenders, they generally charge a higher rate of interest than that of secured lines of credit.

3. Business vs Personal Line of Credit:

A personal line of credit is an ideal type of loan for your personal expenses that can occur repetitively, such as home improvement. However, there is no such rule, and the amount can be used to meet any of your personal expenses. A business line of credit, on the other hand, is one of the most popular loans available for businesses. A business can have financial requirements from time to time, and since the borrowers have to pay interest only for the amount utilised, they usually prefer this facility over a term loan.

4. Fixed Interest vs Floating Interest Line of Credit:

A line of credit is typically offered on a fixed interest rate basis. However, depending upon the lender's policy and terms & conditions, they may offer a line of credit at a floating interest rate.

5. Home Equity Line of Credit:

Home Equity Line of Credit, also known as HELOC, is the most common type of secured Line of Credit. It is secured by the market value of the home minus the amount borrowed. Generally, financial institutions offer credit limits of up to 75% to 80% of the market value of the home after deducting the remaining amount owed on the mortgage. The HELOC is usually offered for 10 years, during which a borrower can utilise the funds, repay them, and reutilise them.

What are the disadvantages of using a line of credit?

While a line of credit offers many benefits, it does come with certain disadvantages, as enumerated below:

1. A line of credit carries a high interest rate, especially for an unsecured line of credit, which is a common type of line of credit availed in India.

2. Since most individuals opt for an unsecured line of credit, they have to pledge their assets. So, in case they fail to repay the loan, they can lose their key asset.

3. The lenders charge annual maintenance charges to the line of credit borrowers, which further increases the cost of the loan.

4. Since financial institutions usually sanction a high credit limit based on your repayment capacity and/or the value of the asset, the funds can be availed of easily. While it is the biggest benefit of opting for a line of credit, the easy access to money may encourage borrowers to borrow frequently and more than what they can manage to repay comfortably.

To conclude:

A line of credit is a great facility that allows you to borrow and repay the money with flexibility and convenience. It is ideal for you if you are going to need money on time to time basis. However, since the line of credit is a high-cost loan, it is necessary to use the credit limit wisely. The line of credit allows you to borrow money instantly, which can increase your debt and put you in a debt trap, especially if you lack financial discipline. If your requirements can wait a little longer, instead of availing of more debt, you can make a solid financial plan which can help you achieve your goals through a smartly done equity mutual fund investment that generates inflation-beating returns while reducing the risk with a diversified portfolio.

Warm Regards,
Ketki Jadhav
Content Writer