Line of Credit: How it Works, Types, Benefits and How to Apply
Need a financial solution that gives you flexibility and control? A line of credit might be the answer. With a line of credit, you can borrow up to a certain limit and pay it back as needed. It’s a convenient way to cover unexpected expenses or finance a project.
In this blog, we have explored the meaning and types of line of credit in great detail. Read on!
What is a Line of Credit?
A line of credit is a type of loan that allows you to borrow money up to a certain limit. Unlike a traditional loan, which provides you with a lump sum of money all at once, a line of credit gives you the flexibility to borrow only what you need, when you need it.
You can think of a line of credit as a “revolving” loan, because you can borrow from it, pay back the money you’ve borrowed, and then borrow from it again if necessary.
Lines of credit are often used for short-term borrowing needs, such as covering unexpected expenses or bridging a temporary cash flow gap. They can also be used for longer-term financing, such as financing a small business or home renovation project.
How does a Line of Credit Work?
In case you apply for a line of credit, the service provider/financial institution will check whether you are eligible to avail of a credit line or not. The main eligibility criteria are a good CIBIL score, preferable above 750, and stable income.
After a borrower qualifies for a credit line, there will be a set period called the ‘draw period’. The borrower can withdraw money from the LOC (Line of Credit) account during the draw period. As per a borrower’s convenience and need, the financial institution will transfer the money via card, cheque, or account transfer.
After a borrower starts withdrawing money, interest starts getting accrued. Once the borrower starts making repayments, the amounts repaid will be added to the LOC account. After the end of the draw period, the repayment period will start.
The borrower will have to repay the remaining balance if applicable.
Also Read: Difference Between Credit Hard Enquiry And Soft Enquiry
Different Types of Line of Credit
- Unsecured Line of Credit
- Secured Line of Credit
There are primarily two types of lines of credit – unsecured line of credit and secured line of credit. Let’s understand these in detail.
1. Unsecured Line of Credit
This is also known as a revolving credit account. The financial institution sanctions an unsecured credit line after checking a person’s credit score and income. One doesn’t need to pledge any collateral to avail of it. However, the interest rate is high because the borrower doesn’t have to pledge assets.
Unsecured Line of credit can be further divided into the following:
- Personal Line of Credit: Individuals opt for it to finance their personal expenses.
- Business Line of Credit: Business owners avail of this loan to meet their business requirements.
2. Secured Line of Credit
When a borrower avails of a loan of credit against collateral, it is known as a secured credit line. In such cases, failure to repay would be followed by liquidation of the assets.
How to Apply for a Line of Credit?
Given below are the steps to apply for a line of credit:
- Step 1: Visit the nearest branch of your chosen lender
- Step 2: Fill up the required form and attach the necessary documents
- Step 3: The bank will check your credit score and income to gauge your creditworthiness
- Step 4: The bank will sanction the LOC after you qualify for the same
Benefits of Line of Credit
Here are a few benefits of line of credit:
- You can borrow only the amount you require without having to pay interest on the entire credit line.
- Borrowers can get flexible repayment options for the principal amount on LOC as long as they pay the interest and other fees.
- Some financial institutions offer the option of secured LOC, which has lower interest rates.
- LOCs can be approved for use over a long tenure of up to three years. During this time, customers can redraw their limits multiple times without incurring additional charges.
- These are ideal for long-term projects with a wide range of unpredictable costs. Also, a LOC is useful to address short-term cash shortages.
- The interest rates for LOC are usually lower than those offered by credit cards, payday loans or cash advances.
- Borrowers can get access to a credit line in a few minutes, making it an ideal option for those who cannot get access to credit cards.
Disadvantages of a Line of Credit
However, there are a few drawbacks to line of credit.
- Borrowers may face difficulty in repayment if interest rates increase.
- Registration fees are applicable.
- LOC is a liability that can restrict the borrower from availing of another loan.
- Resisting the temptation to splurge is difficult because money is readily available.
Difference between Line of Credit and Personal Loans
The table below provides the differences between a credit line and a personal loan:
| Line of Credit | Personal Loan |
| This is a revolving account that enables people to draw, repay and redraw money at their convenience | This is a lump sum amount which is paid back over a fixed tenure |
| One can avail of the requisite amount whenever they want via a cheque/card/account transfer | One receives the entire loan amount after it has been sanctioned |
Also Read: Personal Loan vs Credit Card: Which One Should You Opt For
When to Use a Line of Credit?
Given below are important points about when it’s most appropriate to use a line of credit:
- You can avail a line of credit to fund your education and home renovation
- You can also avail this loan to pay off small debts
When Not to Use a Line of Credit?
Discussed below are important points about when it is not a good idea to use a line of credit:
- If the borrower has an irregular and unstable source of income, using a line of credit is not a good idea
- A line of credit is not an ideal option to fund daily financial needs because having new debts is not a good idea
- A cash loan might be a better idea if the borrower is sure of the amount they would need but doesn’t want to pledge his assets.
Final Word
A line of credit is a flexible loan option beneficial for the borrowers and the lenders. You can choose to avail of a secured or unsecured credit line based on your need. The terms and conditions associated with a LOC are convenient and repaying the loan will not be an added burden. However, you must have a good credit score to apply and avail of a credit line.
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FAQs
Ans: Business credit lines are availed by various companies to address their working capital requirements, payment of salaries, inventory requirements, etc. These are not as flexible as a personal LOC as spending is limited to business-related expenses.
Ans: A personal LOC is offered to individuals with a high credit score (above 700) and a good debt utilisation ratio. Individuals can use this credit facility to meet their urgent or long-term expenses. Borrowers can pledge collateral to get better loan terms.
Ans: Yes, since small startup businesses are prone to losses and emergencies, a LOC is a great choice for them. Moreover, estimating a final value for how much funds a business requires is next to impossible. By having a credit line sanctioned, a startup can get access to instant cash during cash flow crunches.
Ans: Credit lines offer more flexible options for repayment over longer tenures compared to credit cards. They also come with lower interest rates than credit cards, which can charge anywhere from 36-42% for not paying dues on time. However, a LOC does not offer the convenience of credit cards, such as flexible transaction or repayment features.
Ans: The financial institution decides the maximum limit for a LOC account. It depends on an individual’s credit score, income, purpose and repayment history. The borrower will have access to the entire amount once the Line of credit has been sanctioned and use it as per his/her requirement.
Ans: When a person avails a line of credit, he can enjoy the benefit of paying the interest rate only on the amount utilised. They don’t have to pay interest on the unused loan amount. The bank decides the interest rate of a line of credit. It depends greatly on a person’s credit score, repayment history and income stability.
Ans: Availing a line of credit for a startup is a good idea. A startup faces many uncertainties. The business will need funds in the initial stage. A LOC will enable the businessman to access the requisite amount of money as per his need and convenience.
Ans: Applicants need to read and compare the terms and conditions and interest rates of LOC of various banks before choosing the most suitable one for them. They can research online about LOCs. They need to ensure that the bank provides a draft protection facility. One can compare the overdraft facility charges of banks to select the best option for availing of LOC.
Ans: A personal line of credit is a flexible and convenient option if you are unsure of the required amount. You can avail a personal line of credit in the following instances:
– Emergencies
– For supplementing irregular incomes
– For home improvement projects
– Overdraft protection
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Disclaimer: This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information, and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
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