Many are familiar with personal loans and credit cards, but they aren’t the only options if you need to cover an unforeseen expense.
Personal lines of credit are a way to borrow funds based on the amount you need over a set period of time, without putting up any collateral.
“A personal line of credit is a lot like a credit card in that it’s an unsecured, revolving debt product. You can borrow up to your credit limit and use the funds for almost any purpose, but check with your lender for potential exclusions,” says Leslie H. Tayne, financial attorney and founder of Tayne Law Group. “Many borrowers use the cash to cover home improvement projects, emergency expenses or gaps in their income.”
Unlike a personal loan, a personal line of credit allows you to borrow any amount up to your credit limit during the borrowing period, rather than qualifying for one set loan. Additionally, personal lines of credit typically have variable interest rates rather than fixed rates.
Though less common than a personal loan, personal lines of credit can still be a viable borrowing solution for the right situation. Just consider how the variable rate, credit score requirements and other restrictions work for your needs.
[Read: Best Personal Loans.]
How Does a Line of Credit Work?
Personal lines of credit typically require applicants to have good to excellent credit, or a score above 670, to qualify. They won’t be available for everyone.
When you qualify for a personal line of credit, you’ll receive a credit limit and a draw period — marking the time when you have access to this credit — based on your creditworthiness.
“During the draw period, you’ll borrow what you need and make monthly payments on your account, replenishing your available credit,” says Tayne.
Unlike a personal loan, which requires you to make fixed monthly payments on your loan balance immediately after disbursement, you’ll only need to make minimum payments on your line of credit balance. You also only pay interest on the amount you borrow.
“Once your draw period expires, you’ll enter the repayment phase, and you won’t be able to draw any more money. If you need additional funding, you’ll have to apply for another line of credit. You’ll stay in the repayment phase until the debt is completely repaid,” Tayne says.
In the repayment phase, you’ll have to pay back your remaining balance in accordance with your bank’s repayment policy. Exact terms can vary by lender.
Your interest rate on the personal line of credit is variable, meaning it might go up or down over time in accordance with the prime rate. This is a major difference from personal loans, which typically offer a fixed interest rate.
Unsecured vs. Secured Lines of Credit
“A personal line of credit is a way to borrow money without any collateral,” says Laura Sterling, vice president of marketing for Georgia’s Own Credit Union. Personal lines of credit, like most personal loans, generally are unsecured loans.
With a secured loan, the borrower offers up collateral in the form of a car, home, stock or something else of value that the lender can claim and sell to cover the loan if you default on payments. Thus personal lines of credit, like other unsecured loans, are riskier to the lender.
Types of Lines of Credit
There are several different types of lines of credit available to borrowers depending on your financial situation and reason for borrowing. In addition to personal lines of credit, two of the most common alternatives are business lines of credit and home equity lines of credit.
Business lines of credit are used for a more specific purpose — namely to cover short-term cash flow issues with your small business. If you’re seeking funds to cover a personal expense, you’ll want to stick to a personal line of credit or HELOC.
“A home equity line of credit is similar to a personal line of credit but is secured by the equity in your home,” says Sterling. “Because of this, you generally get a much lower interest rate. However, if you fail to make your payments, it could result in foreclosure on your home.”
[Read: Best Home Equity Loans.]
Pros and Cons of a Personal Line of Credit
“The greatest advantage of a personal line of credit is its flexibility, as you can borrow as much as you need up to your credit limit any time you need it,” says Sterling.
In addition to their flexibility, personal lines of credit have several other benefits and drawbacks.
Pros
— Personal lines of credit don’t require collateral.
— You can access funds quickly and draw as much as you need.
— You typically have access to a lower interest rate and higher credit limit than a credit card.
Cons
— Most personal lines of credit charge variable interest rates, so your rate might go up.
— You can only borrow during the predetermined draw period.
— The best terms are reserved for those with good credit.
Where to Get a Personal Line of Credit
Personal lines of credit are not as common as personal loans, which are offered by almost every major banking institution. Most large banks don’t offer personal lines of credit, in fact. Wells Fargo, for instance, stopped issuing personal lines of credit in 2021.
The best place to start looking for a personal line of credit is your local bank or credit union. A few larger banks, such as U.S. Bank, still offer this product as well.
Alternatives to a Personal Line of Credit
If you’re looking to borrow money to consolidate debt, finance a home improvement or cover a medical emergency, you have several options available to you. In addition to other kinds of lines of credit, such as a HELOC, you can:
Apply for a personal loan.
If you prefer a fixed interest rate or the clear payment schedule of a personal loan, it might be the better choice for you. “Comparatively, a personal loan is similar to a personal line of credit but offers a fixed rate and predictable monthly payments,” says Sterling. “Unlike a personal line of credit, you get one lump sum of money that you pay back over time. A personal loan also does not require collateral.”
Put charges on a credit card.
With high interest rates, credit cards aren’t always the best choice for large purchases you’ll need to pay off over an extended period of time. However, if you can qualify for a 0% APR credit card, you might be able to score a year or more interest-free to pay down debt before high rates kick in.
Similarly, balance transfer credit cards offer the opportunity to consolidate debt at a lower rate. “If you have high-interest debt on other credit cards or loans, a balance transfer credit card can allow you to consolidate your debt onto one card with 0% intro for 15 to 21 months,” says Baruch Silvermann, founder and CEO of The Smart Investor. “This can help you save money on interest and simplify your debt repayment strategy. With a personal line of credit, you typically can’t transfer balances from other lenders.”
[Read: Best Credit Cards.]
How a Line of Credit Affects Your Credit Score
Personal lines of credit are considered revolving debt when it comes to how they affect your credit score. They work similarly to a credit card.
When you take out a personal line of credit, the amount of credit granted to you can help to positively boost your credit utilization ratio. On-time payments will also count toward your payment history.
On the flip side, missed payments will negatively impact your score. And if you withdraw too much money against your line of credit, you could end up with a high amount of total debt and a poor credit utilization ratio.
Unlike credit cards, which remain open and boost your available credit until you choose to cancel them, personal lines of credit have a set draw period. Once that ends, you won’t have access to that credit anymore, and you might see your score drop a few points as a result.
Should You Take Out a Personal Line of Credit?
Personal lines of credit can be a great, flexible way to borrow money. Just be careful of their variable interest rates, and make sure you have a repayment plan in mind for the amount you borrow.
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What Is a Personal Line of Credit? originally appeared on usnews.com
