If you’ve ever found yourself needing a little bit of extra cash on hand, you wouldn’t be the only one. When it comes to how you actually go about getting this money, you might have a few different options at your disposal. This could include things like personal loans, credit cards, or even the generosity of family and friends.
Another potential option that you might consider is a personal line of credit. But what is a line of credit and how will it affect your finances moving forward? That’s an important question to ask before applying for any type of credit product. It’s always important to be informed before making any major financial decisions, otherwise you risk damaging your financial standing now and in the future.
One of the most important things to consider is how a personal line of credit might affect your credit score. This is an important three-digit number that can play a big role in your ability to access credit, so you’ll want to make sure that you have an idea of what affects it and how. Today, we’ll take a look at some of the ways in which a line of credit can impact your credit score, as well as some of their potential benefits and when it might be a good idea to steer clear of them.
What is a Personal Line of Credit?
If you don’t know what a personal line of credit, using a credit card as a reference point is a good place to start. Just like a credit card, a line of credit is a type of revolving credit. This means that if you’re approved for one, a financial institution will give you a credit limit that you can draw funds from whenever the need arises, as long as you have available credit and your account is in good standing. Like a credit card, you’ll pay back the money you’ve borrowed with any interest and/or fees required over time, and have the option to make minimum payments before each due date. The amount of your credit limit can be affected by your credit score as well as certain other factors.
What are the Effects of a Personal Line of Credit Loan on your Credit Score?
Before getting into the specific ways in which a line of credit might affect your credit score, it’s important to point out that in most cases, your payments (and any missed payments) you make on your credit accounts will be reported to a credit bureau. These activities are what make up your payment history, which will ultimately impact your credit score.
Revolving accounts like your line of credit will also affect your credit utilization ratio, which is a number that shows how much cumulative credit you’re currently using from all of your revolving credit accounts. This is another important concept to understand. Now, let’s get into some of the ways in which a personal line of credit can affect your credit score.
1. Your Payment History
Like we mentioned, payment history is a big factor when it comes to your credit history, as it accounts for 35% of your FICO score. Because the payments you make on your line of credit loan are likely to be reported to a credit bureau, making these payments on time may have a big impact on your score. On the other hand, missing payments can also have a big effect, and not a good one. That’s why it’s so important to make sure you’ll be able to pay off what you borrow before you draw from your line of credit.
2. Your Available Credit
The amount of available credit you have can also have a big impact on your credit score, as your amounts owed makes up 30% of your FICO score. Because of this, your credit utilization ratio is a key indicator of where you stand on this front. To calculate it, all you need to do is add up the credit limits of all your revolving credit accounts, then add up the total amount you owe across these accounts. Divide your total debt by your total credit limit and multiply this number by 100. For example, let’s say your only revolving credit accounts are a credit card with a limit of $2,000, and a personal line of credit with a limit of $3,000. You’ve used $500 on each account that you have yet to pay back, bringing your total use to $1,000, and your credit limit across both accounts to $5,000.
The calculation would be as follows: $1,000 ÷ $5,000 × 100 = 20.
Here you can see that your credit utilization ratio would be 20%. In general, it’s recommended to keep this number under 30%.
3. Length of Credit History
Another component of your credit score is the age of your various credit accounts. In general, the older the account, the more weight it holds. So, if you have a personal line of credit that you continue to make timely payments on, the age of this account may affect your credit score.
4. Credit Inquiries
When you apply for a line of credit or loan of any kind, in most cases, an inquiry will be made into your credit report. This essentially means that the company performing the inquiry will review your credit reports.
These inquiries will generally either take the form of a hard pull or soft pull. When a hard pull (also called a hard inquiry) is performed, your credit score will usually take a little bit of a hit. This means that if you apply for a line of credit that requires a company to perform a hard inquiry, your credit score may drop a few points. For this reason, you may want to avoid applying for new credit accounts on a frequent basis.
Soft pulls on the other hand will not affect your credit score. They’re generally performed for things like background checks and more.
Potential Benefits of a Line of Credit
At this point, it would be fair to ask why you may want a personal line of credit in the first place, and how it might be able to benefit you. One of their main benefits is how flexible they can be. Because they’re a type of revolving credit, you can draw funds from your available credit as often as you like, as long as your account is in good standing. As you pay off what you’ve borrowed, you can continue to draw funds without needing to apply for another loan. This may give you quicker access to funds than a fixed-term loan might be able to.
When Should I Not Use a Line of Credit?
An important thing to remember before applying for a loan of any kind is that you shouldn’t be taking on debt if you can’t afford to pay it off. This rule definitely applies to personal lines of credit. Why? Well, if you miss payments, you can do some serious harm to your credit history, you may end up needing to pay late fees, and you can find yourself caught up in a cycle of debt that can be incredibly tricky to get out of.
There are also certain specific purchases that you should avoid using your line of credit loan for. For starters, it’s not a great idea to use it to pay for things like restaurant bills, shopping sprees, or any sort of inessential purchase. So, if you were planning to take on debt to fund your next vacation, it might be best to stay home!
Should I Consider a Line of Credit?
While you’ll want to make sure you’re not applying for a line of credit for the wrong reasons, they can definitely be useful if you’re avoiding the red flags listed above and know when to use them responsibly. If you’re facing an emergency expense, a personal line of credit can be a useful safety net to help you deal with the short-term cost if you don’t have enough savings on hand.
This, however, doesn’t mean that you can ignore what we previously said about making sure you can afford to pay off your debt before applying for credit. Make sure to take a look at your budget, assess your financial standing, and look for what’s out there. Take your time looking at different types of lines of credit, different offers from financial institutions, and find something that suits your situation.
If you’re worried about whether or not a line of credit would be the difference between having a good credit score or a bad one, we hope this has helped clear the air! To get a better idea of how you’re using credit, you can get a free copy of your credit report from one of the major credit bureaus – Experian, Equifax, or TransUnion.
In the interim, a line of credit can be a flexible tool to have at your disposal in times of need. Take some time to explore your potential options to find something that suits your situation!