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What is a Line of Credit and How Does it Work?

From time to time, you might find yourself in need of additional money to fund a project, pay a medical bill or cover for an emergency. It can be hard determining where to get access to the cash you need. It may be that a line of credit is just the thing to get you by.

A line of credit (LOC) is an agreement between a bank and an individual that is geared towards establishing the maximum amount of money a customer can borrow. Once agreed upon, the customer is allowed to access the borrowed funds from the financial institution through their bank accounts. They are then required to make repayments on the loans per the terms established with the bank.

Here is how a line of credit works.

How a Credit Line Works

Individuals securing funds from a bank have a maximum amount of money they can access at a given time. They are then required to pay back the loan before being eligible for another line of credit. The financial institution sets the amount to be paid and the duration for which the borrower has to pay it back.

Additionally, secured loans have a lower interest rate compared to unsecured loans due to the risks involved.

One of the advantages to a line of credit is that it is much more flexible compared to other forms of borrowing. This is because the borrower is allowed to access checks and credit cards. With a check draft, one can request funds and then repay it separately without interfering with the line of credit. Additionally, creditors can ask the lender to adjust the premiums based on their cash flow.

Related Content: Three Tips to Boost Your Credit Before Getting a Loan

Types of Credit Lines

There are differences in the lines of credit you can receive. You have the following options:

Secured vs. Unsecured LOCs

Most of the online loans you will find for a line of credit are unsecured. That means borrowers don’t have to place collateral to affirm the line of credit. However, lenders prefer secured loans so that they can recoup their money in the event a borrower fails to repay.

For entrepreneurs, secured loans are deemed to be the best since the borrower can get more funds and at a much lower interest rate compared to the unsecured line of credit. Unsecured loans require the account holder to have a higher credit score. Additionally, there are lengthy procedures before they are approved. Because this is the case, they are not usually a good fit for emergencies.

Related Content: Emergency Fund Basics: The Step on Which All Other Success is Built

Despite the borrower being able to negotiate adjustments on their monthly repayments on loan, the lender can revoke the line of credit. Similarly, the lender may apply a revocable line of credit if they feel the market doesn’t seem to favor the financial institution.

Revolving and Non-Revolving LOC

Revolving lines of credit are often believed to be open-end, or never-ending borrowing accounts as the creditors can secure money, spend it, repay, and borrow again. However, revolving accounts are different from installments loans (closed-end credit accounts) since individuals have monthly installment targets to repay off their loans. Once the loan is cleared, the securer can only apply for another investment to continue spending the funds.

In non-revolving line of credit, the loan limit is set. The interest rate is charged usually, and the repayment period is flexible. However, with non-revolving accounts, once the loan is paid off, the account is then terminated and can’t be used to secure subsequent borrowings.

Examples of Lines of Credit

Why would you ever need a line of credit? Here are some examples of when to think about getting one:

Personal Line of Credit

This line of credit provides individuals entry to unsecured online loans. Customers opening the account are required to have a credit score of 680 and above. The loan can be used for emergencies, overdraft protection, and to fund events.

Home Equity Line of Credit (HELCO)

These are the most common types of secured line of credits. The credit offered usually is equivalent to 75% or 80% of the value of a home subtracting the owed amount on a mortgage. In the same vein, HELCOs often come with a repayment of up to 10 years, after which the draw period on the loan balance is extended. However, the interest to be paid can be reduced if the home used as collateral is renovated during the draw period.

These would often be done is someone wanted to remodel their home.

Business Line of credit

This is a loan secured only when an entrepreneur deems fit. The bank offering the credit first evaluates risks, market value, and profitability of the enterprise before approving the borrowing. Nonetheless, the line of credit can either be secured or unsecured depending on the outcome from the business’s evaluation.

With the above information, you can quickly nail down the best type of loan to take. Regardless of your credit score, or whether you have security, you can be sure of getting funds to finance your course.

Questions for Discussion Below: Have you every used a line of credit? How did it work out? 

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