What Is a Line of Credit?

Life sometimes throws a temporary cash-flow curveball our way that makes it hard stay on top of promptly paying bills. That copay for medical tests to check out a knee hurt in a pickup game. The HVAC that conks out right when the tuition bills are due. Or, as anyone new to the gig economy may be learning in real time right about now: Those first paychecks can take time as clients add you to their payment system.

 
Being able to fall back on emergency savings or a credit card are common ways to cover temporary cash-flow crunches. A less well-known option is a personal line of credit.

By definition, a personal line of credit is a “revolving credit” account that you can tap into as needed to help cover short-term cash-flow problems. Much like a credit card, a line of credit comes with a maximum spending limit, and you’re charged interest only when you actually draw from the line of credit. You can continue to withdraw from the line of credit, up to your maximum limit, and any funds used must be repaid. 

Banks and credit unions have long offered businesses lines of credit to deal with cash-flow hiccups, such as when client payments aren’t coming in fast enough to cover business expenses. A personal line of credit delivers a similar financial bridge for households. Here’s how a line of credit works:

Application process. If the bank or credit union where you have a checking account offers a personal line of credit – not all do – you can usually apply online by answering a few questions. If approved, you typically will be able to start using your line of credit in a day or two. If your current bank or credit union doesn’t offer a personal line of credit, you can search online for options. However, you’ll usually need to open a checking account to be eligible for a personal line of credit.

 
Note that your application will trigger a hard credit inquiry, which can cause a temporary drop in your credit score.

 
No collateral needed. Most personal lines of credit are “unsecured,” meaning you don’t need to pledge an asset as payment if you can’t repay what you tap. Instead, if you default, the account may be turned over to a collections agency. This differs from a home equity line of credit (HELOC), for example, where your home equity is the collateral: Missing too many payments could result in foreclosure.

Preset spending limits. If you’re approved for a line of credit, your preset limit will depend on factors such as credit score, income, and any existing debts in repayment. Credit lines typically max out around $25,000, but can be much higher depending on the lender and your personal financial circumstances. When you repay any used portion, your available credit limit will be replenished by that amount.

When you open a line of credit, its credit limit is added to your total available credit limit – potentially benefitting your credit utilization ratio. But remember: Anytime you tap into your line of credit, it will cause your credit utilization percentage to rise. As a general rule, it’s smart to keep your credit utilization ratio below 30%.

Good credit matters. Because this is an unsecured loan, the lender needs assurance that you’re highly likely to pay back what you use. As a general rule, you will need a FICO credit score in the vicinity of 670 or higher to qualify for a personal line of credit.¹ And the higher your credit score, the lower the interest rate will likely be.

 
The interest rate is variable. Most personal lines of credit charge an interest rate that can move higher or lower, based on changes in an underlying benchmark index. That’s the same way credit cards work. However, line of credit interest rates have been historically lower than those for credit cards.

There are no uniform rules for how a line of credit may work – it depends on the lender. Before you sign on, consider the following key questions:

How long will the line be available? Some lines of credit allow you to tap into the money for a set number of years, such as five or more. This is known as the draw period. After that, you will be required to pay back any borrowed amount within a set time limit – such as another five or more years. Other lines of credit have no set draw period.

What’s the minimum monthly payment? Once you tap into the line, you’re required to start making payments immediately. It may be a set percentage, such as 2.5% of the used amount, or a minimum dollar amount of $25 or more.

 
When does the interest payment start? Lenders may start charging interest immediately, once you tap into a personal line of credit. Even if you are using the line for just a week or two while you wait for your next paycheck, you would still be charged interest. This differs from credit cards, which usually offer a “grace period” of at least three weeks between the end of your billing cycle and when the payment is due, during which time no interest is charged.² Using a credit card may make more sense, especially if you anticipate you can pay the entire balance when the bill is due.

Is there a fee? Some lenders might charge a monthly or annual fee. In some cases, you may have to pay this fee regardless of whether you’re using funds. Other lenders might only charge a fee if the funds are sitting unused.

A personal line of credit can be a valuable option to have at the ready for those occasional times when you find yourself in a short-term cash crunch. If possible, set up autopay to make sure you are always on time with payments. After all, your track record for making timely payments on all bills – credit cards, lines of credit, loans, etc. – accounts for 35% of your FICO credit score.

 
Despite the benefits, it may be wise to avoid habitually relying on a line of credit – particularly if there isn’t an interest-free grace period. A credit card may be a better option.

 
Otherwise, if you find you constantly need to tap into your line of credit, it might be a sign to take a fresh look at your budget to see if there are ways to improve your cash flow. Ideally, you want to be able to save, not just pay the bills. Having money you can set aside to build up an emergency savings fund is the best way to be prepared when you run into a cash-flow jam.