When it comes to taking loans, usually mortgages and other traditional loans come to mind. They may not be more popular, but there is one more loan available which is not talked about as much – the line of credit.
The line of a credit is something to look forward to in emergency situations. When the desired goal is not buying a home or car, but getting access to a loan which can be used in a state of need or urgency. However, you need to be cautious. You may want this amount to help you finance your home's expenses, business overheads or educational expenses. Having said that, you shouldn’t go for this if you have other, more commonly means to finance your expenses.
What is a line of credit & how does a line of credit work?
The line of credit is different from traditional loans. A bank or credit union gives you a pre-decided amount as a loan, which you can then use to deal with your emergency situation. Interest, however, will be applicable from the moment you first withdraw the amount.
This is a highly flexible loan. You can withdraw an amount when you need to and return at your convenience. Unlike mortgages, no fixed monthly installments are required. However, the interest rate may vary, thus the exact cost can only be estimated at best.
Once qualified for the loan, you will get a time period to withdraw the amount. That time period usually lasts for a few years and is called the draw period.
What are the line of credit requirements?
To get a line of credit, you need to meet some requirements in order to be eligible for it. The eligibility criteria almost resemble that of mortgages and conventional loans. Before granting you a loan, the lender would look at the following:
Your Credit Score
The lender would check your credit score to see if you qualify for this type of loan - you need to have a score of at least 690 or more. This means that all previous records in your credit history need to be in immaculate order.
Having a historical record of all payments made in a timely manner is essential if you want to make an impression on the lender. You must look credible in the eyes of the lender through a credit history filled with on-time payments to get approved a line of credit.
Your Financial Status
Another factor that will help you get approved for a line of credit is your financial status. Your financial status should appear stable for the foreseeable future, showing that you’re more than capable of repaying the borrowed amount, with interest, back and in a timely manner.
Pros and cons of a line of credit vs credit card or other loans
There are many advantages to the line of credit especially when you don't want money to buy a home, car etc. You can think about this loan for following reasons:
- The most important factor that differentiates it from conventional loans is its flexibility. You can withdraw the amount you want to and return it according to your own flexibility.
- Interest rate is applicable only on the borrowed amount
- Lesser restrictions compared to traditional loans and mortgages
- No apparent risk to you if loan is unsecured
- Lower annual percentage rate (APR) than that of credit cards.
- Interest rate may change which can lead to greater payment amounts.
- Annual fees could prove to be an additional burden.
- You need a very good credit score
- High balances can reduce your credit score significantly.
Difference between a secured line of credit and an unsecured line of credit
Depending on who is getting the loan and for what, the line of credit can be separated into two categories, secured and unsecured.
Secured line of credit - The most common ways from Home equity line of credit (HELOC) to savings account or deposit certificates
A secured line of credit allows you to get a loan after depositing some form of collateral. The collateral helps secure the loan for the lender in case of missed, late or non-payment. The most common way of getting a secured line of credit is home equity, also called Home Equity Line of Credit or HELOC.
HELOC is the type of line of credit where you can use your home equity as collateral to secure your loan. In such a case, interest rates may vary, leading to overall increased monthly payments and the amount of the loan will be a maximum of 85% of your home's value.
But what if you are not a homeowner or don't want to put your home at stake?
You can still opt for securing your loan with your savings account or deposit certificates.
The drawback to the secured lines of credit is that your assets are always at risk - if you are unable to make the payments on time, you’re at risk of losing your home. The lender would take possession of the asset you initially placed as collateral.
Unsecured line of credit - The best way to not put any assets at risk although higher interest rates
If you don't have anything as collateral to secure your loan, or don’t want to put your assets at risk, you can go for an unsecured line of credit. For this, you won't need to pledge anything as collateral, you’ll simply get a loan on the basis of your credit history and credit score.
You don't have to take any risk when you go for this kind of line of credit, but the lender does. That’s the reason the interest rates for these lines of credit are higher, resulting in higher monthly payments.
Policies for the unsecured lines of credit may vary from lender to lender, too. Moreover, you might have to pay annual fees to keep your account open. The major drawback for this line of a credit is a higher interest rate and the annual fees you’ll need to pay.
Some Important Considerations Before Using The Line Of A Credit
Using money from the line of credit may sound tempting, however, it can lead you into a severe debt trap. Thus, using a line of credit wisely and only when needed is advisable.
- Before using the line of credit, you may want to evaluate your financial capabilities and whether you can afford repayment
- You should review your credit score before opting for a loan, because the lender most definitely will
- Don't use the credit line for something like a like vacation. Use the amount only for the most important things or for emergencies
- Don't go for a home equity line of credit if you can't afford the monthly payments – you’re at serious risk of losing your home if you don’t have a plan to pay back the money to the lender
- Most Importantly, do your research before taking out any loans. Understand the policies of different lenders, then choose what works best for you.
How to apply for a line of credit?
You can apply for the line of credit through different banks. Although banks might not advertise much about these loans, they still do offer these facilities. Even private lenders are offering these lines of credit to borrowers - you may need to check the availability of any such offerings in your particular area.
A Few Words Of Caution
If you don't want to go for traditional mortgages to buy a house or need to use the loan for something else you can go for a line of credit. Remember, however, that it does come with a set of problems of its own, which you’re bound to run into, if you’re not careful.
There are a few advantages to using a credit line but some difficulties so be careful when using it.
Before applying for a line of credit, whether secured or unsecured, make sure to improve your creditworthiness. Ensure that you’re in a safe and stable place financially before making any decision. Once you get qualified for a loan, don’t mismanage the amount and make it a habit to diligently make monthly payments on time. Save your credit score from dipping and don't get into any problems because of late or missed payments.
No matter how fascinating it sounds, additional money from an institution always carries a fair bit of risk - don’t let it spiral out of control into a viscous circle of debt. You must play it very safe and smart when it comes to credit lines.