A line of credit provides households and businesses with access to cash availability when there is a temporary cash flow problem. Should a major emergency expense arise or a short-term drop in income occur, a line of credit makes it possible to stabilize a budget.
It creates stabilization because it is a flexible loan that is usually obtained from a financial institution. Some credit lines are available through alternative providers, such as a peer-to-peer network. This loan then creates a cash flow cushion which prevents households or businesses from tapping into their cash reserves.
In many ways, a line of credit is similar to a credit card. You’re able to access funds when it is needed. You can repay what you’ve used at any time and use the credit whenever it is needed, for as long as the account remains open.
Having a line of credit provides several advantages and disadvantages which must be carefully considered to determine if this financial product is right for your budget.
List of the Advantages of a Line of Credit
1. A line of credit is usually cheaper than using a credit card.
Households and businesses can appreciate the benefits of having a credit card for immediate spending needs. The only problem with a credit card is that it will usually carry a high APR. Some consumer cards have a standard APR of 29.99%. If you can be approved for a line of credit, then the interest rates are usually lower than what you’d find with a similar credit card at the same credit score. You’ll have the same purchasing power and be required to repay less over time.
2. It reduces the temptation to purchase unnecessary items.
From a consumer perspective, the availability of credit on a credit card, along with its ease of use at the point-of-sale, makes it a temptation to purchase items that are not needed. From a business perspective, the spending on a credit card is something that can have tax advantages, which creates a temptation to purchase items as well. A line of credit is usually linked to a banking account, which reduces impulse purchases for most individuals.
3. A line of credit makes cash availability happen quickly.
Compared to other types of credit, a line of credit can be processed in as little as 24 hours. Even for larger credit lines, the turnaround for a line of credit is usually a few days. For a credit card, it may be 2-3 weeks from the start of the application process. If you’re dealing with a home equity line of credit for your extra cash flow, you might be waiting several months to have the availability you want.
4. It is usually an unsecured line of credit.
Most of the time, a line of credit is an unsecured loan that can be used at your discretion. That is another similarity it has to the standard credit card. If you happen to default on the debt for some reason, because it is unsecured, you are at a very low risk of losing important assets. Your credit score will take a hit for 7-10 years with a default, but for some, that is better than losing a car, a home, or the building where your business is operating.
5. The cost of setting up a line of credit is usually low.
The initial cost of setting up a line of credit is usually similar to that of having a credit card. Some may even be free. Like the annual fee of a credit card, most credit lines have an annual maintenance fee that is $100 or less for the average consumer. Six-figure credit lines may see higher maintenance fees. If you do not use the line of credit for a specific time period, usually 12 months or more, then another fee may apply to the account. Otherwise, you’ll find that it doesn’t cost much to get access to the cash you need for short-term issues with this lending product.
6. A line of credit offers a lot of flexibility to the consumer.
With a line of credit, you are only borrowing the money that you need to have. You only access the credit when you need to have it. You’re able to use the same credit as many times as you need to have it, assuming that you’re repaying what you use over time. In most circumstances, you’re able to use the line of credit for any purpose you may have. From a business perspective, you may be asked to guarantee that the money will be used for business purposes and not personal reasons.
7. There are multiple structures available for a new line of credit.
The most common structure of a new line of credit is called a “draw” option. It functions very similar to a credit card, allowing you to spend money as needed, like a credit card, while making a structured monthly payment. Once you repay the full amount, the monthly payment goes away. Another option is called “demand.” You would still access the line of credit as you would with the draw method, but the lender can demand full repayment at any time. The third option is a “balloon” payment. At the end of the term, a large payment would be required, while smaller monthly payments would be allowed.
8. You may draw up to 100% of your limit without restrictions.
Once you are approved for a new line of credit, you are permitted to withdraw up to 100% of the approved limit you’ve been given. That makes it easier to handle large purchases because you can approach a seller using cash. At the same time, you have a guaranteed repayment schedule that allows you to budget for the new expense. Although fixed-rate loans may be better for very large purchases because they have lower interest rates, a line of credit tends ot offer some extra flexibility.
List of the Disadvantages of a Line of Credit
1. A line of credit still has a higher interest rate than other lending products.
A line of credit is usually cheaper than the average credit card. It also tends to have a higher interest rate than a home equity line of credit or a secured credit line. That because you’re dealing with different layers of risk. If you have a secured loan, then you’re providing a guarantee to the lender. If you default on a secured debt, then what you used for collateral can be claimed by the lender, even if you put your house up for security.
2. The fees for a line of credit vary widely throughout the industry.
When you apply for a line of credit, you will find that the interest rates, the maximum amount permitted, and other variables with this lending product will widely vary. You’re forced to shop around with several different lenders to see what kind of deals are available to you. That means each application you submit generates a hard credit pull, which will negatively impact your overall credit score if you have enough of them.
3. A line of credit operates under a different set of regulations.
Credit cards are regulated more heavily compared to a line of credit. You’ll want to make sure that you check on all the fees that might be charged when you open a new account. You must check to see what penalty fees may apply. There may be additional charges for going over your credit line, making a late payment, or not accessing your line of credit. This is another place where you’ll need to spend a lot of time comparison shopping to ensure that you’re getting a good deal.
4. Almost all lines of credit come with an adjustable interest rate.
There are some lines of credit that come with a fixed interest rate. If you find one, stick with it if the offer is fair. That is because most lines of credit have an adjustable interest rate. That means the lender is permitted to increase your APR in the future, which means your payments will go up whenever that happens. With a line of credit, a rate increase applies to the existing balance and new chargers, which means a hefty increase might make it impossible to meet your monthly payment obligations. Always look to see how often the interest rate can be adjusted, and by how much, before agreeing to the line of credit.
5. There is still the temptation to overspend with a line of credit.
A line of credit might not provide the same temptation to spend that a credit card offers, though that doesn’t mean the temptation disappears. For people who struggle with spending and tend to max out their personal or business credit cards, then a line of credit may not be the right choice to make. You may find yourself maxing out another credit line, creating even more of a debt obligation to handle in the future.
6. A line of credit will almost always have a required minimum.
You must apply for a specific minimum amount when looking at a line of credit. In the United States, most financial institutions have a $1,000 minimum for a new line of credit. High interest credit lines may be available at $500, though these are intended more for people with a marginal credit score Some credit limits may be extended well beyond $100,000, depending on your personal income and credit history.
7. There is no grace period for spending with a line of credit.
When you decide to access a line of credit, the interest on the amount you access will begin to accrue immediately. Then the interest is charged on the outstanding balance on the line of credit until the withdrawal made is fully repaid. That means you’ll pay more for any purchase you make, unlike a credit card, which provides a grace period of up to 28 days before interest will be applied to a purchase.
8. You usually need to have a good credit score to qualify.
For most new lines of credit, you’ll 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’ll also need to have a strong credit history over the past 5-7 years, with minimal collection attempts or negative public record entries. You must also provide an established record of income, provide proof of employment, and self-employed individuals may be required to provide tax documentation over several years. Business credit lines have similar requirements, including consistent proof of sales, to be approved.
The pros and cons of a line of credit make it possible to stabilize personal or business finances when there are emergencies or unexpected lapses of income. Like any lending product, there are a variety of options available in today’s marketplace. Some will make a positive impact and others will not. It is up to you to perform your own due diligence to ensure the line of credit you select is able to maximize the power of your finances.