A personal line of credit (Or PLOC) is an amount of money that you can draw on and make payment towards in irregular intervals. This is the bank’s money that you are using, but it is quite different from a traditional loan mainly in terms of flexibility.
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With regular loans, you would borrow an agreed upon amount and make regular fixed payments for a set period of time until the balance was cleared. With a personal line of credit, you can borrow any amount within the agreed limit and replenish that amount by making payments towards the balance.
The line of credit will usually stay open for as long as the holder wishes to keep it. Personal lines of credit are mainly used by people who do not have regular income streams and wish to avoid risking an account overdraft which will incur very high interest rates.
This article will touch on the ins and outs of personal lines of credit, how they work, the types of lines of credit available, why you might need one, and how to get one.
How Does a Line of Credit Work?
A personal line of credit is opened at a bank whereby a credit limit is agreed upon, which can be anywhere from $1,000 to $100,000, that the borrower can avail. A time period is then set, which can be a finite amount of time, or it could be as long as the borrower wishes.
The set interest rate will start accruing immediately after the first use of the line of credit. If the borrower repays the balance preemptively, interest will only be charged on the remainder. Having said that, there is usually a baseline minimum payment amount, generally about 1% of the outstanding balance.
In most cases, lines of credit are classified as an unsecured line of credit, meaning there is no collateral which will result in a higher rate of interest than a secured loan like a mortgage. Borrowers might reach an agreement with the bank where the line of credit is backed with collateral in order to lower the interest rate.
The main distinctive feature of this type of open end credit line, compared to traditional loans, is the built-in flexibility. Borrowers do not need to take a fixed amount out, but just as much as they need within the credit limit. Another separating feature is the revolving nature of open end credit line where borrowers can renew the balance by simply making a payment outside the fixed baseline schedule.
Different Types of Lines of Credit
There are different types of lines of credit based on the nature of the terms. These can be broken down into a secured line of credit and an unsecured line of credit.
A secured line of credit is one that is backed with some collateral, usually a house, a car, or even a boat. When collateral is in play, the interest rate charged is lower than otherwise, as this presents a lower risk to the lender. A Home Equity Line of Credit, or HELOC, is one such loan where the borrower can borrow up to a percentage of outstanding equity, and pay back as much as desired above the baseline.
A business line of credit that is collateralized by its assets is also an example of a secured line of credit. Businesses who avail this line of credit are usually ones that have irregular cycles and subsequently irregular income streams.
Conversely, an unsecured line of credit is one where the borrower does not put up any collateral, which inevitably represents a greater risk for the lender. As such, the interest rate charged will be quite a bit higher. Also, the qualification standard will be higher for the same reason. The lender will usually require a higher credit score and a generally better financial position.
An unsecured line of credit functions very similarly to a credit card, the main differences being that the qualifications are more stringent, the limits are higher, and the interest rates are usually lower.
Revolving vs. Non-Revolving Lines of Credit
A revolving line of credit, or an open end credit account, is one where the borrower can avail any amount of credit desired as long as it is with the initially set limit. The revolving nature is where the borrower can constantly renew the line of credit available by making payments.
For example, if the line of credit was set at $10,000 and the borrower has borrowed $5,000, all the borrower needs to do in order to renew the limit is to repay the $5,000 or part of it in order to bump the limit back up towards $10,000. Interest will only be levied on the outstanding balance of the line of credit.
A non-revolving line of credit, or what is known as an installment loan, is much more fixed in nature. The borrower borrows a fixed amount of money and repays in fixed installments for an agreed upon time period. Once the balance has been settled, the account will be closed, and the borrower will need to file a new application if he/she wishes to avail another loan.
Examples of installment loans include mortgages, car loans, and personal loans. Installment loans need not be secured. However, the same interest rate dynamics will apply. The nature of an installment loan that differentiates it from an open end credit account is its finite nature where it will be closed once the terms have been fulfilled.
Why Do You Need One and What are Its Uses
One of the main advantages a personal line of credit has over a credit card is that is usually carries a lower interest rate. It also carries a higher credit limit than credit cards.
So, for those who are able to qualify for a personal line of credit, it might be a more favorable alternative to getting a credit card. On top of that, the damage to your credit score resulting from a large balance is generally not as much with a personal line of credit compared to a credit card.
Also, if you are someone who is prone to temporary shortfalls in cash flow, for example if you are a seasonal worker, then a personal line of credit may suit your needs very well. Since you know you will be getting an outsized cash flow at some point in the near future, in the meantime you can avail the services of a personal line of credit and settle the balance once the cash flow starts up.
Another benefit of having an unsecured line of credit is that no collateral is being risked. Even though you will probably be made to pay a higher interest rate, having no collateral means that if your circumstances take a turn for the worst, you are not risking having to turn over your assets to the bank that might have to sell it at an unfavorable price.
How to Get Yourself A Line of Credit
To get a personal line of credit the bank will look at credit score, credit history and current financials. It would be best to have that all settled and ready before you apply. This can not only save you time but also gives you the ability to fix any issues before it can impact your application on interest rates.
Check your Credit Report for issues – It’s advised that you review your credit score on all three main credit bureaus, seeing as you do not know which one the bank will use.
Compile financial details – Much like applying for a loan, the financial institution will be looking at your tax returns, employment information, investments, and bank statements, in an effort to assess your creditworthiness.
Comparison shopping – Be sure to look around at all the banks in your area to find out the terms of their personal lines of credit, as well as their qualification standards in order to find out which ones you might qualify for and which ones have the most favorable terms from your perspective.