What Is a Personal Line of Credit: Pros, Cons, and When to Use It
Many of us are constantly searching for loan options that enable us to buy assets and improve our fortune-growing abilities without jeopardizing our long-term financial health. And while many consumers prefer traditional fixed bank loans or simply racking up high-interest credit card debt, few are willing to explore the lesser-known personal line of credit.
So what is a personal line of credit? In our guide, we’ll walk you through the basics and cover all of the requirements as well as some of the risks associated with this loan option. We’ll also tell you where you can find the best deals on the market.
What is a personal line of credit?
A personal line of credit or PLOC is an agreement between two parties, usually a financial institution and a borrower, which defines the amount of money the borrower can access at any given time. There are different types of repayment structures and interest expenses. Depending on the lender and individual circumstances, some borrowers may be charged application and maintenance fees for these personal lines of credit.
Many consumers use a personal line of credit to expand businesses, consolidate or refinance existing debt, pay medical bills, or renovate their homes. These loans aren’t typically intended to be used for one-time purchases. In some ways, a PLOC is a cross between a credit card and a personal loan. There are different types of lines of credit, including personal and business ones. Generally, they can either be secured or unsecured.
Types of Lines of Credit
Unsecured LOCs vs Secured LOCs
The most basic distinction between these two is that secured LOCs involve the use of collateral as a guarantee, while unsecured ones don’t. Ultimately, it’s the lender that decides whether you are eligible for an unsecured personal line of credit or a secured one. The latter is easier to get because the loan is secured against your assets, while the unsecured option requires a good credit score.
Most lenders are more comfortable with handing out secured loans. The collateral put down by the borrower offers a means to recoup the advanced funds in the event of a borrower defaulting. There are many reasons for nonpayment, from financial difficulties to even the death of a borrower, but all result in losses for lenders.
Secured lines of credit are also advantageous for borrowers. In addition to the larger credit limits, they don’t have to deal with the high annual percentage rate or APR that comes with an unsecured line of credit. In addition to the high credit score requirement for borrowers, unsecured facilities also pose a high risk for lenders. As such, financial institutions work to minimize their exposure by limiting the amount of funds that can be borrowed and by charging higher interest rates.
Revolving vs. Non-Revolving Lines of Credit
While lines of credit offer a great deal of flexibility for borrowers, there are limits to these financing arrangements. Here, it’s important to make a distinction between a revolving line of credit and a non-revolving line of credit.
Revolving lines of credit are arrangements where borrowers get access to an account with a specific credit limit that they can use and reuse. The funds are repeatedly made available to the borrower after payments are made to the revolving credit account.
It’s important not to confuse these revolving accounts with mortgages or auto loans. With those installment loans, the borrowed amount of money is repaid in equal monthly installments. Once you pay off an installment loan, you cannot access the funds again unless you apply for a new loan facility.
On the other hand, a non-revolving line of credit shares some characteristics with the revolving credit definition: a credit limit is established, and funds can be borrowed for any reason. But there is one major difference. The credit pool does not replenish after the loan has been repaid. Once the loan is repaid, the account is permanently closed.
Aside from the personal line of credit, there are a few other LOCs:
Home equity line of credit (HELOC)
This LOC is secured by the market value of the home minus the amount owed, which is used to determine the size of the line of credit.
Demand line of credit
This is either a secured or unsecured line of credit loan that enables customers to borrow funds on an on-demand basis. Meanwhile, the lender can require the amount borrowed to be repaid at any time. This can include interest plus principal or interest-only, depending on the terms of the LOC. The borrower can spend up to the credit limit at any time.
Securities-backed line of credit (SBLOC)
This is a type of LOC in which collateral is provided by the securities in a brokerage account.
Business line of credit
This is a revolving loan with a fixed amount of capital, which is generally designed for short-term business needs. It’s a credit limit based on the market value, profitability, and risk taken on by the business. It can be secured or unsecured.
How does a personal line of credit work?
We’ve established that a personal line of credit grants customers access to unsecured funds, which can be borrowed, repaid, and then borrowed again, essentially making it a revolving line of credit.
To open a personal line of credit, you’ll need a credit history free of defaults, a reliable source of income, and a credit score of 670 or higher. If you have a lower score, there are some emergency loans for bad credit you can consider instead. In addition to these personal line of credit requirements, having savings can help, and even though you can qualify for personal lines of credit without collateral, having stocks or CDs helps.
Borrowers apply for personal lines of credit for a variety of different reasons, including weddings, travel and entertainment, emergencies, and overdraft protection.
Great as it sounds, a PLOC has both advantages and disadvantages.
- Access to funds: Once you’ve been approved for any credit amount, you can take out as much as you want, whenever you want, up to the credit limit.
- Strategic usability: Opening a line of credit enables you to adopt a strategic approach to dealing with finances. Suppose you have a $15,000 student loan and a $10,000 auto loan. With a PLOC, you can take out $25,000 in credit and pay these off at once. The big advantage here is that you can end up with a lower interest rate.
- Flexible lending: Based on your payments, the lender may offer you repeated access to the line of credit. This is referred to as an open-end credit transaction.
- The risk of unsecured loans: Personal lines of credit are unsecured loans because they do not involve collateral. This translates into high interest rates because the lender assumes all the risks.
- High credit score required: The line of credit interest rates aren’t the only thing you have to worry about. Due to the risk assumed by the lender, getting a PLOC requires a good credit score. Some lenders may accept 670, but others prefer scores of over 700.
It’s important to know what you’re getting into when taking out a personal line of credit. Understanding your obligations will also help you decide whether this is the ideal solution for your financial situation or if you should opt for alternatives such as personal loans or HELOCs.
Personal lines of credit vs. HELOC
Unlike HELOCs, personal lines of credit aren’t secured against your assets. That’s because the former option allows you to pull equity out of your home for loan financing. This introduces collateral, and now that the credit facility has become a collateralized loan, interest rates will typically be lower than with a personal line of credit.
Personal Line of Credit vs Personal Loans
The biggest difference between a personal line of credit and a personal loan is that the latter is a lump-sum payment and a closed-end transaction. The lender issues the funds and expects repayment based on an agreed timetable.
How to qualify for a line of credit
The qualifying process for a personal line of credit is quite simple. Once you have chosen a lender willing to finance the personal line of credit and reach a mutually beneficial financial agreement, you’ll be asked for information regarding your current financial picture. In addition to your credit score, required documentation may include the following:
- Employment history
- Your investment portfolio
- Bank statements
- Statement indicating what the credit line is intended for
- Proof of income
How to apply for a personal line of credit
Applying for a personal line of credit is a straightforward process that you can generally complete online. Once you decide on a lender, as well as the credit limit your financial condition requires, you’ll have to provide personal information, including your name, social security number, employment details, and income. Many lenders will give you access to the funds within two business days once the application has been approved.
We started this guide by asking a simple question: what is a personal line of credit loan? By now, you’re familiar with a range of topics related to PLOCs. In short, a personal line of credit is a strategic financial tool that can be used to manage debt and cover unexpected expenses. Their effectiveness is determined by individual circumstances and needs.
What is a personal line of credit and how does it work?
A personal line of credit is a revolving credit account that allows you to borrow funds up to a certain limit. Similar to most line of credit loans, you take the amount you need from the available balance and then pay interest on that amount. The open-end credit transaction allows repeated access to the funds.
What is the difference between a personal loan and a personal line of credit?
A personal loan differs from a line of credit in that with a loan, you borrow a fixed amount of money, repay it at a fixed rate and over a fixed period of time along with interest charged on the borrowed amount. With a personal line of credit, you can borrow up to a certain limit, repay the funds and borrow again.
Does a personal line of credit help credit score?
Most potential borrowers trying to figure out what is a personal line of credit are essentially worried about their credit score. In truth, PLOCs can help credit scores, but the conditions for meeting this can be a little complex. Generally, when you accept a line of credit, it appears on your credit report as a new account. If your available credit is never used or you use just a fraction of the total amount available, then your credit utilization rate may be lowered, improving your credit score.
Is it bad to get a line of credit?
A line of credit is generally a bad idea only if you know you can't afford payments or you don’t have a stable income.
For years, the clients I worked for were banks. That gave me an insider’s view of how banks and other institutions create financial products and services. Then I entered the world of journalism. Fortunly is the result of our fantastic team’s hard work. I use the knowledge I acquired as a bank copywriter to create valuable content that will help you make the best possible financial decisions.
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