First, let’s talk about the options you have when you need to borrow money. Broadly speaking, you can usually apply for either a loan or a line of credit. With a loan, you get one lump sum of money and start paying interest immediately, regardless of when you use the money.
By contrast, a line of credit gives you access to a set amount of money that you can borrow when you need it. But you don’t pay any interest until you actually borrow.
Lines of credit can be for personal or business use. In this context, we’ll focus on personal lines of credit.
Personal lines of credit are usually not secured, which means you don’t have to put up any assets as collateral to get the line of credit. Secured lines of credit are backed by assets, such as your home or your savings account.
When you apply for a line of credit, having good credit scores can help you get a lower interest rate. Some lines of credit may have fees, such as an annual fee, and limits on how much you can borrow.
After you get approved for the line of credit, you have a certain period of time — called the “draw period” — in which you can borrow money from the account. A draw period can last for several years. The lender may give you special checks or a card to use, or transfer the money to your checking account, when you want to borrow the money.
Once you borrow money from your line of credit, interest begins to build up and you have to start making at least the minimum payments, which will increase your available line of credit as you pay them. But when your draw period ends, you have to enter the repayment period, in which you have to pay off any remaining balance. Remember, making only minimum payments can make you pay more interest in the long run.
How does a Line of Credit affect your Credit Scores?
When you apply for a line of credit, the lender may check your credit reports. This could make your credit scores drop a little bit for a short time.
When you get approved and you take the line of credit, it usually shows up on your credit reports as a new account.
If you don’t use your credit limit, or only use a small part of it, it may lower your credit usage rate and boost your credit scores. Your credit usage rate shows how much of your credit limit you’re using at any moment. If you borrow a lot of the line, that could raise your credit usage rate, which may damage your credit scores.
Also, your credit health may get worse if you pay late.
What is a Secured Line of Credit?
A secured line of credit is a type of borrowing that requires you to put up something valuable as collateral for the line of credit. One example of a secured line of credit is a home equity line of credit, or HELOC.
HELOCs let you borrow money based on the equity you have in your home and use your home as collateral for the line of credit. They usually have a variable interest rate, which means your payments may go up over time.
Usually, the bank will cap the amount you can borrow to up to 85% of your home’s appraised value, minus the amount you still owe on your first mortgage. When banks decide your interest rate, they look at other things besides your credit scores, such as your credit history and income.
If you don’t own a home or don’t want to use your home as collateral, you may be able to get a line of credit that’s secured by a savings account or certificate of deposit.
The risk for a secured line of credit? If you fail to make the payments, the lender may seize the asset that secured the line.
What are Unsecured Lines of Credit?
An unsecured line of credit is a type of borrowing that doesn’t require you to put up anything valuable as collateral for the line of credit. But the lender is taking on more risk with unsecured loans, which could make the interest rates higher than with a secured line.
Each unsecured line of credit has different terms. The limits may vary from a few thousand to a few hundred thousand dollars. Some lines of credit have fees — for example, you might have to pay an annual fee to keep the account open.
How are Credit Cards and Lines of Credit Different?
Credit cards are like lines of credit. Both are a revolving line of credit, which means you can borrow money from it up to the credit limit, then pay it back (plus any interest you owe), and borrow it again.
But credit cards and lines of credit are not the same. They are two different products that lenders offer, and there are some important differences between them.
With credit cards, you don’t have a draw period — you can use the card as long as the account is open and in good standing. Many have rewards programs, and if you can pay off your balance on time and in full each month and your card has a grace period, you may not pay any interest at all. This means that credit cards may be a better option for everyday spending, if used wisely.
The downside to credit cards: They may have higher interest rates than lines of credit, so carrying a balance on one may cost you more. They may also have lower limits than personal lines of credit, and you could face high fees and APRs if you want to get cash with a cash advance from a credit card.
How to use a Line of Credit Wisely
Before you get a line of credit — whether it’s secured or unsecured — check your credit scores and take steps to improve your credit health so that you can get a lower interest rate. Then figure out how much you need and how you want to use the money.
If you need a flexible way to get money, it may be a smart idea to get a line of credit, says Bruce McClary, vice president of communications at the National Foundation for Credit Counseling®.
But, he warns, “if you’re borrowing because you’re trying to escape from financial trouble with another loan … there’s a bigger problem that needs to be fixed that can’t be solved by keeping on borrowing.”
How to Decide when to use a Line of Credit
When is Line of Credit not a Good Idea?
If you know you can’t make the payments or your income is not steady, a line of credit may be a bad choice. If you miss payments, your credit will probably get worse. And if you have a secured line of credit, the lender may take the asset that you used as collateral.
If you know the exact amount you need and you don’t want to risk losing anything, you may be able to get an unsecured personal loan with lower interest rates than an unsecured line of credit, depending on your credit.
If you’re using the line of credit for basic needs, or to pay for short-term expenses like eating out and trips, that could be a sign that you’re having financial problems and shouldn’t borrow more money.
When is Line of Credit a Good Idea?
If you need the money for a home-improvement project, education costs or other kinds of big expenses, a HELOC or secured line of credit may be a smart option — as long as you’re sure you can pay it back. Plus: The interest you pay on the HELOC may be tax-deductible.
An unsecured personal line of credit may help you combine several small debts you’re paying off into one payment with a lower APR, while not using any collateral (depending on the terms of each line of credit and how good your credit is).
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