Personal Loans

What Is a Personal Line of Credit and How Does It Work?

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A personal line of credit offers a flexible way to borrow money. Like a credit card, it lets you access funds only as needed but it may come with more favorable terms, like a larger credit limit.

If you need to borrow money regularly but can’t pin down a total loan amount, a personal line of credit could be useful for a large expense like medical bills or a home improvement project. Here’s a guide to help you better understand this borrowing option, and how it compares to three popular alternatives.

How does a personal line of credit work?

A personal line of credit is usually an unsecured loan, which means you won’t need a house or car as collateral in order to qualify. As with a credit card, it typically comes with an adjustable interest rate, a fixed payment schedule and a credit limit on how much you can borrow. It will also have set periods for when you can draw — or borrow — money and when you have to repay it.

In many cases, you can only get a personal line of credit — or qualify for the best terms — if you’re already a customer with a particular lender, perhaps through a savings or checking account. If you do qualify, expect a credit limit in the range of $1,000 to $100,000, and possibly $250,000 or more if you have substantial financial holdings with the lender.

With a personal line of credit, you can usually borrow up to your credit limit and then borrow again after you’ve repaid what you owe plus interest. The length of time you can access funds often runs from six to 60 months. In some cases, though, it might be open-ended, with no set date for your credit access to expire.

Expect a few spending restrictions with a personal line of credit; for example, you may not be able to use it for investment or business purposes. The following expenses probably will qualify:

  • Home improvement projects
  • Car repairs
  • Medical bills
  • College tuition
  • Refinancing student loans
  • A major expense, like a wedding

Unsecured vs. secured lines of credit

Some lenders may be willing to offer you a secured line of credit that comes with better terms — like a lower interest rate or larger credit limit — in exchange for collateral like a savings, certificate of deposit (CD) or money market account.

If you only have fair credit, a secured line of credit is likely to come with a larger credit limit and lower interest rate. An unsecured personal line of credit might be the better option if you have strong credit and don’t want to risk losing a valuable asset.

Personal line of credit: Pros and cons

The biggest advantage of a personal line of credit is its flexibility. Unlike a personal loan and other financing options where you receive a lump sum of money upfront, a line of credit lets you withdraw funds as much — or as little — as you’d like. This means you won’t have to pay interest on any money you didn’t borrow.

Most personal lines of credits come with variable interest rates. Some lenders offer fixed rates, but a variable rate will increase and decrease with market conditions, so make sure you can keep up with monthly payments. Because a personal line of credit offers easy access to money, it might cause you to borrow more than you need or can afford.

Interest will start accruing on your account as soon as you start withdrawing funds, and you’ll need to repay what you owe according to a preset payment schedule. This usually means paying at least a minimum amount monthly. Some lenders may let you delay payments until after your draw period ends, while others may require you to repay the entire amount at that time in the form of large balloon payment.

Pros and cons of personal lines of credit
Pros Cons
  • Money withdrawals as needed
  • Constant access to funds
  • Only pay interest on the money you borrow
  • Funds can be used for almost  anything
  • Variable interest rates can make future payments hard to predict
  • Application and maintenance fees
  • Possible fee for each withdrawal
  • High balance on a regular basis can lower credit score
  • May increase the temptation to overspend

As with a credit card, every time you make a payment to a personal line of credit, the amount paid back raises your available credit limit — a plus for your creditworthiness. But watch for payment terms.

The minimum payment you make may initially include interest only, or both loan principal and interest. It will vary depending on what you still owe, but you can expect to pay either a flat fee, like $25, or a percentage of your balance (say 1% to 2%), whichever amount is higher.

Besides interest charges, your personal line of credit may also come with an application fee, an annual maintenance fee (usually $25 to $50), late payment fees and a cash advance fee every time you take out money.

Where to find a personal line of credit

You’ll find a personal line of credit most often at a bank or credit union, although some online lenders offer them, too. Here’s a brief overview of each option:

  • Bank: Both large national banks and smaller regional banks offer personal lines of credit, although many lenders require you to already have a financial account with them. In some cases, you may also need to live near a local bank branch.
  • Credit union: You’ll mostly likely need to be a member to get a personal line of credit. Because of their not-for-profit status, credit unions are less likely to charge annual fees or application fees.
  • Online lender: An online lender may be able to get you a personal line of credit quickly, like access funds in just one business day. Online lenders often have more lenient lending requirements than banks and credit unions, but watch for lower credit limits. Some online lenders offer personal lines of credits in only a few states.

How to apply for a personal line of credit

Since a personal line of credit is an unsecured loan, potential lenders will look closely at your credit score, income, other debts and your overall ability to repay this type of loan. In general, to qualify for this type of loan, you’ll need good to excellent credit.

  1. Check your credit: Visit AnnualCreditReport.com to get copies of your credit reports from Equifax, Experian and TransUnion. This way you’ll know what kind of loan terms to expect with your particular credit history.
  2. Decide how much you want to borrow: Pin down, as best you can, what your ultimate borrowing needs might be. For a large sum of money, a secured line of credit might come with a higher credit limit, lower interest rate, and a longer draw term.
  3. Research lenders and compare quotes: You can easily research lending options online, to compare APRs as well as maximum credit limits, minimum draw amounts and any potential fees or penalties.
  4. See if you prequalify: Fill out a preliminary application online or in person. You’ll be asked to provide basic information about your income, employment and financial obligations. Some online lenders promise to reply within a few minutes.
  5. Choose a lender and submit a formal application: Your lender will ask for documentation to prove your identity, income and employment status, so pull together documents like a government-issued photo ID, pay stubs, tax forms and recent bank statements. At this time your lender will also conduct a hard credit check.
  6. Start taking withdrawals: Once your application is approved, you may be able to access your line of credit in as little as one business day. Your lender may offer  line-of-credit checks, a special card that works like a credit card or online access so you can transfer funds directly into a savings or checking account.

How a personal line of credit compares

Credit card

Most credit cards come with an interest-free grace period of about 21 to 25 days as long as you pay off your entire balance by the end of that time. They often offer special perks, too like cash back, travel points or introductory zero-interest balance transfers that let you bypass interest charges up to 18 months if you pay off your balance by the end of that time.

A personal line of credit will probably come with a lower APR and a higher credit limit. However, expect stiffer qualifying requirements like a higher credit score.

Is a credit card or personal line of credit right for me? A credit card offers a convenient way to cover smaller ongoing expenses and possibly collect rewards. A personal line of credit might be a smarter choice if you’re expecting a large expense and qualify for a lower interest rate. With both options, try to keep your total credit charges to no more than 30% of your available limit; this will help your credit score.

Personal loan

With a personal loan, you borrow a set lump of money and repay it with interest via regular monthly payments over an agreed-upon term. Once you’ve used up a personal loan, you’ll need to apply for a new loan if you need more cash.

A personal loan is less flexible than a line of credit because you won’t be able to borrow money when you need it. Still, a personal loan usually comes with a fixed interest rate, which can make it easier to budget loan expenses.

With both personal loans and lines of credit, you’ll need to watch for potential fees, and possibly prepayment penalties for paying off your balance early. A personal loan may also come with an origination (or processing) fee that’s 1% to 8% of the total loan amount.

Is a personal loan or personal line of credit right for me? A personal loan can be a smart choice for a large, one-time expense where you know the final cost. It may also make sense if you’re worried about possibly overstepping your budget with extra interest costs. If you don’t know how much money you’ll need, a line of credit may provide peace of mind. Remember that most personal loans and lines of credits are unsecured loans, so you may not qualify for either option without a strong credit history.

Home equity line of credit (HELOC)

A HELOC lets you tap into your home’s equity to receive a set amount of funding that you can then draw upon to pay for a variety of expenses. Like a line of credit, it has both a draw period (usually 10 years) and a repayment period, often 15 to 20 years. With a HELOC, you may be able to borrow up to 80% or 90% of the value of your home.

A HELOC comes with a variable interest rate, though it will likely be lower than for a personal line of credit. However, this type of loan is secured by your home. With a HELOC, you’ll also want to make more than just minimum payments during the draw period to avoid getting stuck with a huge repayment bill later on.

Is a HELOC or personal line of credit right for me? A HELOC may be a reasonable pick If you have enough equity in your home, would prefer a lower interest rate and are comfortable with a certain amount of risk. Also, the interest you pay on it might be tax-deductible if you use it for home improvement purposes.  If you don’t want to use your home as collateral (or don’t own a home), your only option might be to see if you qualify for a personal line of credit.
 

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