When we think of a loan we tend to think of a single lump sum received in one go. Interest on that loan begins immediately. Personal lines of credit are loans, but they work a little differently. With a personal line of credit, you can borrow money only as and when you need it. You can keep your line of credit open for years. Intrigued? Let us explain how it works.
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Credit is available in many forms. There are the cards we carry in our wallets and the mortgages we carry on our homes, among others. As you go through adulthood building up a solid credit score and a relationship with the bank where your checking account lives, you may gain access to another type of credit, the personal line of credit.
How a Personal Line of Credit Works
If you have a checking account with a bank you may be eligible for a personal line of credit from that bank, provided you have good credit. Depending on the size of the line of credit you want, the underwriting process will likely be quite straightforward.
You’ll be offered a certain Annual Percentage Rate (APR) that represents the percentage of your borrowed money that you’ll pay in interest to the bank each year. The larger the sum you want to access, the more cautious the bank will be. You may have to show proof of your income and assets before getting approved for, say, a $70,000 line of credit.
To draw on your line of credit you’ll either use special checks or contact the bank and request that funds be transferred to your checking account. Personal lines of credit are great for long-term projects like home renovation, when the amount of money you need to borrow varies from month to month. However, personal lines of credit tend to have higher interest rates than you’d get with a Home Equity Line of Credit (HELOC).
If you establish a personal line of credit with your bank, at the end of each month you’ll get a bill that shows how much you’ve borrowed and how much interest has accrued. Like a credit card statement, your bill will suggest a minimum payment.
Our advice? Pay more than the minimum payment every month you can afford to do so. That way, you’ll keep more of your money and pay less in interest. Personal lines of credit can go on for years. Depending on your bank, you may be required to pay off the money you’ve borrowed each year. Other banks may allow you to carry a balance from one year to the next.
If you can’t keep up with the payments on your personal line of credit, your bank will eventually suspend your line of credit. The bank may also resort to what’s known as the right of offset. Translation? They can take the money you owe them directly from your checking account.
Before committing to a personal line of credit, it’s important to make sure you understand the terms of the agreement. Don’t be tempted to tap into your personal line of credit for everything you want. Like credit cards, personal lines of credit can easily tempt borrowers into overspending. Exercise caution.
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The Personal Line of Credit vs. The Personal Loan
Both personal loans and personal lines of credit are unsecured loans. What do we mean by that? A mortgage is a secured loan. That means there is something of value that secures the loan, something (the home) that the lender could repossess in the event of nonpayment. Unsecured loans are loans based on credit worthiness that have no physical object acting as collateral.
With a personal loan you’ll apply for a lump sum loan and be quoted an interest rate. If you decide to go forward with the loan you’ll pay an origination fee and get all the money you requested at once. You start racking up interest as soon as that lump sum payout hits your account. If you need an injection of credit right away (to start a business or consolidate debt from high-interest credit cards), a personal loan may be just the ticket.
Personal lines of credit work differently. Your bank will quote you an interest rate that is lower the better your credit score. The big difference? You don’t have to take all the money at once. If you need money here and there for an ongoing expense, a personal line of credit provides more flexibility than a personal loan and ensures that you’re not paying interest on money you don’t need.
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If your credit score is in good shape and you’re considering a personal line of credit, shop around for the best deal you can get. Don’t just look for a low interest rate. Look for a fixed APR so that you’re not blindsided by changes to your interest rate. Compare fees for both origination and late payment. Only borrow what you need and what you can afford to pay back.
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