Understanding a Line of Credit
No matter how financially responsible you’ve been, life has a way of throwing you a curveball when you least expect it. And when those curveballs come with emergency expenses, it may be a good idea to have a safety net in place to help you deal with them.
In these instances, your first line of defense should be your emergency fund. But what if you don’t have one? Or what if it’s not big enough to handle whatever emergency expenses you’re facing on its own? If you end up in a situation like this, a personal line of credit (LOC) may be the safety net you need to help you handle your emergency.
But what is a line of credit, exactly, and how do you go about getting one? We’re going to answer these important questions, look at some different types of lines of credit, and dive a little deeper on when you should and shouldn’t consider applying for a personal line of credit.
What is a Line of Credit?
Step one in this exercise is to put a line of credit definition into simple terms. Basically, a line of credit is a form of loan where you’ll have the ability to draw money when you need it from a pre-determined credit limit. If you’re approved, you’ll qualify for a specific loan amount (just like you would when approved for a credit card), and you’ll then be able to request a draw on your LOC whenever you need funds, assuming you have credit available and your account is in good standing.
A key point here is that a line of credit is a form of revolving credit. This means that you don’t need to use the full amount you’re approved for all at once, and instead you have the ability to draw as much or as little as you need, when you need it. As you pay off your balance, you can continue to borrow money when you need it from your available credit. This also means that when you do draw funds, the payments you’ll be making will be based on the amount you’ve drawn, not the total amount of your line of credit.
Unsecured vs. Secured Line of Credit
One really important distinction to make between different types of lines of credit is whether they’re unsecured or secured. With an unsecured line of credit, you won’t be required to provide collateral in order to qualify. Because of this, if your application is approved, the financial institution would be taking on more risk by lending money to you, which may result in higher interest charges and/or fees than you’d typically see with a secured line of credit.
When a line of credit is secured, you’ll need to provide collateral in order to be qualified. If you end up defaulting on your loan, the financial institution may seize whatever assets you’ve put forth. Because you’ve mitigated some of the risk to the lender by providing collateral, secured loans will often come with lower charges than if they were unsecured.
What is a Personal Line of Credit?
A personal line of credit is meant for just that: personal expenses. More specifically, they’re generally meant to help you handle unexpected emergencies. This could include things like:
- Urgent medical expenses
- Emergency auto repairs
- Essential home repairs
If you run into an emergency and your emergency fund can’t cover it, this is where a personal line of credit for emergencies can come in handy. It can be a fast and simple solution to fall back on in case you find yourself facing emergency expenses without the savings to deal with them.
Other Types of Lines of Credit
Aside from personal lines of credit, there are more types of this product that may be available depending on your situation and what you would be using the funds for. These include:
Home equity line of credit (HELOC): This is a type of a secured line of credit where the asset you’re putting up is your equity in your home. The limit on your HELOC is partially determined by how much equity you have in your home. They’re often used if you’re doing a home improvement project but don’t know the exact cost, as it can help you stay flexible throughout the process.
Business line of credit: As you may have guessed, this type of LOC is meant for business expenses. This could include things like buying new equipment, purchasing inventory, or dealing with unexpected costs. They may be a more flexible option than certain other types of business loans, as you won’t need to apply for a new loan every time your business needs more money.
When Should You Consider a Personal Line of Credit?
Like we’ve already mentioned, personal lines of credit are generally meant to be used for emergency expenses that your emergency fund can’t fully cover. They can be a useful financial safety net to have in place in these types of scenarios. But as important as it is to understand their uses, it’s just as important to understand what they’re not meant for. They should never be used for things like:
- Shopping sprees
- Long-term savings plans like college or retirement
And remember, even if you do end up in an emergency situation and are thinking of applying for a loan, make sure it’s a loan you can actually afford. You don’t want to take out a loan and get caught in a never-ending cycle of debt.
Applying for a Line of Credit Loan
When you do end up pulling the trigger on your line of credit application, financial institutions may evaluate you in a few different ways to decide whether you’d be a trustworthy borrower. Your credit score is often one important factor that they look at, but that may not always be the case. For example, to qualify for a personal Line of Credit offered through CreditFresh, you’ll need to:
- be of legal age to contract in your state of residence
- be a US citizen or a permanent resident
- have an active bank account
- have a regular, consistent source of income
- have a valid contact number and an active email address
Here are some things that you want to do to prepare before you apply for a revolving line of credit.
1. Review Your Credit Report
It’s never a bad idea to check in on the health of your credit score, and doing so before you apply for a loan is as good a time as any. You’ll have the opportunity to check your credit report once every twelve months for free from each of the three major credit bureaus – Equifax, TransUnion, and Experian.
You should also keep an eye out for potential errors on your report that could be damaging your credit score. You may be able to get these errors removed if you take the right steps.
2. Organize Your Documentation
Generally, a financial institution will want to see certain information from you that can include things like your income, your state of residence, and your Social Security number. Before you apply for a loan, it may help to speed up the process by having all of this information at the ready.
3. Research Your Options
Applying for a line of credit is a big decision, so before you complete an application, make sure to do your due diligence and explore some of the options that may be available to you. After all, not all lines of credit are created equal, so it’s important you do your research and try to find the best option for your situation. Ask yourself questions like:
- How much will I be charged?
- Will my limit be big enough?
- Are there any additional fees?
Personal Line of Credit – Frequently Asked Questions
What is a Minimum Payment?
When you have a balance that’s outstanding on your revolving line of credit, you may have the option of making a minimum payment during your billing cycle. This is the amount you’ll be required to pay to make sure your account stays in good standing.
The minimum payment will be calculated for that specific billing cycle and must be paid by the due date stated in your periodic statement.
Your minimum payment will be made up of charges, as applicable, and may also include a partial payment towards your principal (the amount you’ve borrowed). While you’ll have the option of making minimum payments instead of paying off your balance in full, it’s a good idea to pay off as much as you can to avoid accruing more interest.
What is the Difference Between a Line of Credit and an Installment Loan?
There are a couple of distinct differences between these two types of personal loans that could help you decide which one you’re best suited for. If you’re approved for an installment loan, you’ll be given a fixed lump sum that’ll you’ll need to pay back through a series of fixed installments over a pre-determined period of time. This stands in contrast to revolving credit, which allows you to draw funds up to your available credit limit, as long as you’re meeting your minimum payments and continuing to pay down your balance as you go.
What is a Credit Limit?
A credit limit is the maximum amount of funds that you’re able to draw. If you’ve been approved for a $1,000 credit limit, the most you’ll be able to draw at one time would be $1,000. You can draw any amount of money up to your credit limit, as long as you have available credit.
For answers to more frequently asked questions, please visit our FAQ page.Get Started