What is a Line of Credit:
A line of credit is an arrangement in which a flexible, revolving loan facility is granted by a financial institution, usually a bank, to an individual customer or a business. It establishes a maximum loan balance that the financial institution permits the borrower to access or maintain. A customer can access the funds at any time, subject to a maximum preset limit in the agreement and fulfilling other terms and conditions established by the financial institution. The lenders charge an annual fee and require the borrower to make timely minimum payments while granting a line of credit facility. Both secured and unsecured line of credit facilities are available but an unsecured facility is difficult to apply and it also has a higher interest rate to cover the risk.
When to get a line of credit facility:
It is not cost-effective and convenient for a borrower to take out a loan every now and then, repay it, and then keeps on continuing the cycle. A line of credit can be a useful source of funds in an emergency. It is most valuable in situations where repeated cash outlays are required, but the amount is not known upfront, for example, home improvements and renovations, repairs and other emergency fixes etc.
Particularly, different categories of lines of credit are available to tackle various kinds of variable costs.
- Personal line of credit can be obtained from a bank where a customer maintains a checking account so that regular transfers/payments in to and out of the account can be made by the customer. The facility can both be secured, by attaching a personal property to the loan, and unsecured resulting in higher interest payments.
- Home equity line of credit (HELOC) can be obtained either from the mortgage lender or other financial institution. A borrower can access funds with a HELOC for home improvement projects or other repair and maintenance or emergency fixes requirements.
- Business line of credit is useful both for startups and other established companies. A startup can use the facility to establish a consistent inflow of cash to tackle the various cash based expenditure requirements. For a more established company, use of line of credit can be a smart move for taking the business to the next level. For instance, Snapchat has recently taken out a line of credit to fund its growth.
Things to consider:
Before taking out a line of credit facility, check your credit information at annualcreditreport.com and check your credit report with some of the leading credit bureaus such as Experian, TransUnion and Equifax. Keep all your business documents such as bank statements, tax returns, investment record, permits and licenses etc. in order.
A borrower should pay careful attention to the amount of fee charged by the lender, interest required to be paid and the repayment schedule before obtaining any funds. Also, compare the rates and terms of various financial institutions when applying for a line of credit in order to secure the best possible deal.
A line of credit is normally a cheaper option (lower interest rates) and offer more flexible repayment schedules than a credit card. Lenders do not charge interest if there is no outstanding balance on a line of credit facility. Businesses can use this facility to meet their immediate cash expenditure requirements, for example, to pay the quarterly tax payments as there normally is a timing difference between the accounting profit and the receipt of cash. The credit score of the borrower can be improved if he takes out a line of credit loan, use it and then repay it in a timely manner. Moreover, unlike a traditional loan method, for example, a mortgage or auto loan that can only be used for the predetermined purpose, there are fewer restrictions on the use of funds borrowed under a line of credit. Thus the borrower can use the funds at his own discretion wherever he considers it fit.
An unsecured line of credit, although is cheaper than a credit card, pawnshop or payday loans, but it is more expensive than traditional, secured mortgage or auto loans. In case of an unsecured facility, the interest rate charged varies with movements in bank rates which can result in the borrower paying very high interest relative to the amount borrowed. Another problem with a line of credit is that banks typically reserve the right to cancel the agreement or lower the borrowing limit at any time which makes things further complicated. For instance, just recently banks have slashed their credit lines for the troubled energy companies due to lower crude prices.
Bottom line is that a line of credit is not inherently good or bad, it depends on the usage of funds obtained through it. It is important to plan your funding strategy to cover any annual lump-sum payments required as part of the line of credit agreement and to not use more credit than is absolutely necessary. Know your limits and don’t let yourself get caught in a debt spiral.