Definition: A line of credit (LOC) is a unique and flexible borrowing method offered by banks and other financial intermediaries to individuals, business firms, and governments. It is similar to a credit card because it allows the user to avail of a limited amount whenever needed and for whatever reason. This limited amount is referred to as the credit limit. It is the highest amount a client is permitted to withdraw via a line of credit.
Like conventional bank loans, users of lines of credit also have to make interest payments, albeit such interest payments can change with time. Lines of credit usually must be approved by the lending institution based on the client’s credit rating and relationship with the lender, among other requirements.
Content: Line of Credit (LOC)
Types of Line of Credit
As noted in the definition above, there are several types of lines of credit that can either be secured or unsecured (as well as revolving or non-revolving). Some are discussed below:
Personal Line of Credit (PLOC)
These are funds meant for all kinds of personal expenditures, e.g., home renovation. A PLOC is an unsecured and mostly revolving line of credit whose interest rates are usually lower than those of credit cards. They can easily withdraw, pay back, and borrow again, making them ideal for clients who do not enjoy the regular income.
Though PLOCs are unsecured, clients who possess potential collateral securities such as stocks or certificates of deposit are in good standing for approval. PLOCs also require that clients have a reputable credit history (often with zero defaults).
Business Line of Credit (BLOC)
A BLOC can help business firms take care of financing needs, which can be in the form of major expenses or operating costs such as inventory purchases, staff wages, servicing of equipment, etc.
Before approval, the lender estimates the market value, profitability, and riskiness of the company and its credit rating and then takes a decision. A BLOC may be secured or unsecured with the secured type, usually attracting lower interest charges due to lower risk in case of default.
Home Equity Line of Credit (HELOC)
A HELOC uses home equity (the difference between the market value and the balance owed on the mortgage) to facilitate borrowing. In the US, the credit limit is usually between 75% to 80% of the home equity. For instance if 80% of a home valued at $690,000 is $552000 and the home’s mortgage balance is $170,000, then the credit limit is $382,000 ($569,000-$170,000).
HELOCs are the most prevalent type of LOCs. Unlike PLOCs, HELOCs are secured, implying that a borrower stands to forfeit his or her home (which serves as collateral) should he or she default on the terms of the contract. However, the collateral security brings about reduced interest charges.
Securities-Backed Line of Credit (SBLOC)
SBLOCs are secured LOCs in which the borrower’s securities (such as stocks, bonds, and mutual funds) serve as collateral. They enable users to access their investment portfolios without having to pay tax or use their credit cards. They are also non-purpose loans and can be used for a range of expenditures but not for trading in securities.
The loans are arranged to be perpetual in nature, and the borrower is mandated to make monthly interest payments. Payments on the principal are discretionary, meaning that the borrower can pay at any time he or she decides.
How Does a Line of Credit Work?
As noted above, those seeking LOCs need approval from lending institutions. Some factors that can lead to being approved include a good crediting rating, sound debt-to-income ratio, high home equity, etc.
LOCs have what is referred to as a ‘draw period’ and ‘repayment period.’ The former period is the time duration within which the client can make withdrawals from his or her line of credit. It can last for several years (sometimes for up to 10 years or more).
The lending institution may provide you with a unique check or card to facilitate easy transactions or move the funds to your checking account. Upon your maiden borrowing, you’ll be required to make minimum payments (or sometimes interest payments) in the draw period, which returns to replenish your line of credit.
At the termination of the draw period comes the repayment period, during which the client is then mandated to make interest payments and repay the principal. Note that the above terms may vary according to the lender and the type of LOC.
For a Secured LOC
An intending HELOC borrower has to first determine his or her credit limit before seeking approval. A simple way to calculate the limit is presented below (adapted from the HELOC definition above).
Present home value = $690,000
80% of home’s market value = $ 552,000
Amount owed as mortgage = $170,000
Therefore credit limit = $569,000 – $170,000 = $382,000
For an Unsecured LOC
Say you intend to make some personal expenditures (e.g., home renovation) and subsequently apply for a $70,000 PLOC approved with a condition of monthly interest payments, among others. After about 60 days, you’ve spent $$49,000 of the credit, leaving a $21,000 balance. If you made an interest payment in the first month, then your line of credit increases by the same amount as the interest payment you made.
Uses of LOC
LOCs provide a wide range of financial cover. Few are highlighted below.
- For home renovation/improvement projects
- Provide funds during sudden needs for finance
- Can help fund real estate purchases
- Bridges finance gaps due to irregular income
- Can serve as collateral for viable business investments
- Funding of financially demanding projects
- Can help offset tax bills
- Provides overdraft protection for frequent check users
- Helps companies take care of major and operating expenses
- Can help pay education fees
- Payment of utility bills, etc.
Advantages of LOC
There are numerous benefits of borrowing via line of credit. Some of these include:
- Quick access to funds: LOCs are convenient and flexible, allowing users to borrow funds on-demand with a provision to repay and borrow again.
- Structured interest payment: There is also no need to pay interest until a first withdrawal is made.
- Helps bridge gaps in money demand: LOCs can provide instant funding for those whose incomes are irregular and/or those who have a sudden need for expenditures.
- Viable alternative: LOCs can act as a superior option when compared to conventional loans and credit cards that sometimes lack flexibility.
- Helps develop a sense of responsibility: The requirement of good credit ratings by lending institutions can help potential and existing clients learn to develop habits like honesty, credibility, and accountability, leading to a better society.
Disadvantages of LOC
While a LOC is a form of credit, certain drawbacks make it an unfavourable option sometimes:
- Variable and higher interest rates: LOC interest rates can change with time, leading to higher risk and uncertainty. They are also usually higher than those of conventional loans, especially unsecured LOCs.
- May sometimes involve lengthy protocol: The procedures for approval may be seen as a bit complex by some clients. This can have a discouraging effect on some potential borrowers.
- Risk of asset forfeiture: Like in all cases of secured borrowing, there is a risk of default and forfeiture of assets used as collateral security.
Thus as we have learned that there are various types of LOCs, all of which may be secured or unsecured in nature, the borrower must wisely decide before borrowing funds through this method.