Your guide to understanding lines of credit
According to the definition of what is a line of credit of the CFPB, or Consumer Financial Protection Bureau, an agency linked to the U.S. government, a line of credit is a loan that you access from time to time.
In the US financial market, this score establishes customers' access (draw periods) to financial products and services. For example, credit cards, financing, loans, as well as more affordable rates and interest rates.
If you are a person who hates going into debt and paying in installments, and pays everything in cash, get ready to change your mindset.
What is a line of credit?
As we have just said, in short, lines of credit are resources made available by financial institutions to individuals or companies. They can be in the form of loans or credit cards, for example.
Usually, lines of credit are provided for specific purposes, such as the purchase of real estate, cars, corporate equipment etc.
Credit score basics
The credit system in the United States is composed of three main players: (i) finance companies; (ii) credit bureaus; (iii) and consumers.
Your financial information, whether it regards credit card accounts, loans, or other types of credit, is electronically recorded at the three credit bureaus by each of your creditors. And this occurs on a monthly basis.
These agencies are TransUnion, Equifax, and Experian. They collect and store credit information for future reference.
Benefits of having a line of credit
The great benefit of this financial product is, once the line of credit is approved, you will have an amount on hand to use whenever you need it.
This amount will be flexible. There is no one-size-fits-all credit line format. It varies according to the needs of each applicant.
However, there are maximum limits for each line of credit granted. But you do not have to use the entire amount allowed.
The credit line works as follows: within the maximum limit that the institution has offered you, after you pay off the debt, the limit value returns to the maximum. And you can continue to use it as you wish.
If you do not pay the portion of the limit that you have used within the time limit, penalties and interest may be charged. This will depend on the terms and conditions you signed up for.
With this in mind, what are the credit risks anyway?
Risks associated with having a line of credit
Credit risk is generally defined as the risk of a debtor not fully settling its commitments in a timely manner (default).
The management of this risk covers: origination; loan or debt management; collection; and recovery.
The risks, in a very summarized way, are factors to be considered mainly because they result from the debtor's financial intelligence.
It is of utmost importance that you know all the main risks involved in credit agreements between parties. Knowing this, we have created a list and disadvantages of a credit line to help you.
1. Extremely high interest rates
A line of credit usually has a higher interest rate than other credit products.
This is because of the different levels of risk. For example, if you have a secured loan, you provide collateral to the lender.
In this case, if you fail to pay a secured debt, the lender can claim what you have used as collateral. Even if you put up your house as collateral.
2. Resist the temptation to spend more
A line of credit may not provide the same temptation to spend as a credit card, but that doesn't mean the temptation goes away.
For people who struggle with their spending and tend to max out their personal or business credit card limits, a line of credit may not be the right choice.
You may end up maxing out the limit on another line of credit. And, as a result, creating an even larger debt obligation to manage in the future.
3. There will almost always be a minimum requirement
When looking for a line of credit, you must ask for a specific minimum amount. In the United States, most financial institutions have a minimum of $1,000 for a new line of credit.
High interest lines of credit may be available for $500, although they are more often aimed at people with marginal credit scores.
4. You must have a good credit score to qualify
For most new lines of credit, you will need to have a credit score of at least 690. Some institutions may require you to have a credit score of 750 or higher.
You must also have a solid credit history for the past five to seven years.
What is the difference between a line of credit and a loan?
In the world where monetary transactions play a huge role, knowing the difference between a loan and a line of credit is important. For they are ways of satisfying emergency needs for money.
Both credit options have relatively low interest rates and offer a tax benefit. However, it is recommended to consult a tax specialist regarding terms and interest rates.
A line of credit gives you convenience and flexibility as various amounts can be withdrawn as long as you are within the defined limit. A line of credit gives you the advantage of making only a minimum payment.
A loan, on the other hand, is recommended if the need is for a single large purchase. A loan requires you to pay a fixed amount.
Companies usually opt for the line of credit. A loan, on the other hand, is used by individuals for large one-time purposes.
What is the difference between a line of credit and a credit card?
They are pretty much the same thing, except for the card. Essentially, while all credit cards are lines of credit, not all lines of credit are credit cards.
Therefore, one can obtain a line of credit that is not associated with a card.
Does a line of credit affect your credit score?
Personal lines of credit are typically recorded as revolving credit by credit reporting agencies. Consequently, both your credit line's maximum credit limit and your balance impact your credit utilization.
The credit report also reflects your payment history. Depending on how you manage the account, this may help or hurt your credit score.
However, as these personal line-of-credit accounts become less prevalent, some banks may discontinue their availability. If this occurs, your available credit will decrease and your credit history may become shorter.
However, you dont need to worry so much because there are loans whose purpose is help you to build a good credit history, such as credit-builder loans.
How can you use your line of credit?
Apply only for the amount you need. Often, the limit of the line of credit available is much higher than you need.
Remember that these transactions sometimes involve high interest. So, manage your interest costs. Check with different institutions and banks and see which one offers the best interest rates.
Use credit lines wisely. They should be safety nets for when you need immediate cash to cover unexpected expenses.
For other purposes it is preferable that you have adequate financial planning so that you don't have to pay interest.
Is it worth getting a line of credit?
As you advance in your career and increase your net worth, it can be empowering to know that a reliable lender can provide you with the funds you need to make a major purchase or reduce the cost of old debts.
Obtaining a personal line of credit may be a good idea when you need access to funds for a variety of life events.
Lastly, the answer you seek depends on your current financial scenario, and how you deal with it.
Could having flexible access to funds help you achieve your financial objectives and reach your next milestone? Without you losing track of your own limits? Take all of this into consideration before making a final decision!
