A line of credit can be a flexible and powerful financial tool for individuals and businesses. Unlike traditional loans that provide a lump sum of money, a line of credit gives borrowers access to a set amount of funds that they can draw from as needed. This flexibility makes lines of credit particularly useful for managing cash flow, handling unexpected expenses, and taking advantage of time-sensitive opportunities.
In this blog, we’ll break down the basics of lines of credit, how they work, the different types, and when it might be beneficial to use one. We’ll also highlight the key differences between revolving and non-revolving lines of credit to help you decide which option best suits your financial needs.
What Is A Line of Credit?
A line of credit (LOC) is a pre-approved borrowing limit that you can access on an as-needed basis. Unlike a traditional loan, which provides you with a lump sum of money upfront, a line of credit allows you to borrow, repay, and borrow again, up to the maximum credit limit.
Lines of credit are typically unsecured, meaning they do not require collateral like a home or car to back the loan, though secured lines of credit are also available, especially for businesses. Interest is charged only on the amount you borrow, not the total credit limit, making it a flexible option for managing unpredictable expenses.
How Does A Line of Credit Work?
A line of credit functions similarly to a credit card but with lower interest rates and typically larger borrowing limits. Here’s how it works:
- Approval: You apply for a line of credit through your financial institution, such as Heritage Financial Credit Union (HFCU). The lender evaluates your creditworthiness, income, and other financial factors to determine whether to approve your application and how much credit to extend.
- Credit Limit: Once approved, you’ll receive a credit limit, which is the maximum amount you can borrow. You are not obligated to borrow the entire amount; instead, you can draw funds as needed.
- Draw Period: During the draw period, you can withdraw funds from the line of credit, either by transferring money to your checking account or by writing checks tied to the credit line. You only pay interest on the amount borrowed, not the entire credit limit.
- Repayment: After borrowing, you’ll need to make regular payments to repay the amount borrowed, plus any interest accrued. As you repay the borrowed amount, your available credit is restored, meaning you can borrow again if needed.
- Renewal: Many lines of credit are revolving, meaning they remain open as long as you make the required payments and don’t exceed your credit limit. Others may have a specific term, after which you must repay the remaining balance in full.
Types of Lines of Credit
There are various types of lines of credit available, each suited to different financial needs. Let’s explore the most common ones:
1. Personal Line of Credit
A personal line of credit is an unsecured line of credit typically used for personal expenses, such as home improvements, medical bills, or covering short-term financial gaps. It’s a flexible option for individuals who need access to funds but don’t want the commitment of a traditional loan.
Benefits:
- Flexibility in borrowing and repayment.
- Lower interest rates compared to credit cards.
- Access to funds as needed, rather than borrowing a lump sum.
When to Use: Personal lines of credit are ideal for managing variable expenses, unexpected costs, or large purchases where you want to maintain flexibility. At HFCU, our personal line of credit is referred to as our Universal Line of Credit or UNLOC.
2. Home Equity Line of Credit (HELOC)
A home equity line of credit (HELOC) is a secured line of credit backed by the equity in your home. This type of credit typically offers higher limits and lower interest rates than unsecured lines of credit.
Benefits:
- Larger credit limits, especially for homeowners with significant equity.
- Lower interest rates due to the secured nature of the loan.
- Interest may be tax-deductible if used for home improvements.
When to Use: A HELOC is a great option for homeowners looking to finance major home renovations, pay off high-interest debt, or fund large expenses.
3. Business Line of Credit
A business line of credit is designed for business owners who need to manage cash flow, cover operational expenses, or finance short-term projects. Like a personal line of credit, businesses can draw from the credit line as needed and repay the funds over time.
Benefits:
- Provides access to capital for everyday operational needs.
- Flexibility to borrow only what’s needed, helping manage cash flow.
- Interest is only charged on the amount borrowed, not the full credit limit.
When to Use: Business lines of credit are beneficial for managing day-to-day expenses, inventory purchases, or covering seasonal fluctuations in cash flow.
Revolving vs. Non-Revolving Lines of Credit
Understanding the difference between revolving and non-revolving lines of credit is essential when deciding which option is best for your financial situation.
Revolving Line of Credit
A revolving line of credit allows you to borrow, repay, and borrow again, as long as you stay within your credit limit and make the required payments. This type of credit is often associated with credit cards and HELOCs.
How It Works:
- You can continuously draw from the line of credit during the draw period.
- As you repay the borrowed amount, your available credit is replenished.
- You only pay interest on the amount borrowed, not the total credit limit.
Advantages:
- Continuous access to funds without reapplying.
- Flexibility to borrow as much or as little as needed within your credit limit.
- Can be used for ongoing financial needs or unexpected expenses.
Disadvantages:
- Interest rates may fluctuate, especially with variable-rate lines of credit.
- It’s easy to accumulate debt if you’re not careful with repayment.
Non-Revolving Line of Credit
A non-revolving line of credit provides a set amount of funds that you can draw from, but once you use the credit, you cannot access it again. Once the balance is paid off, the account is closed. Unlike revolving credit, the funds are not replenished after repayment.
How It Works:
- You borrow a set amount, and once repaid, the credit line is closed.
- You cannot re-borrow from the line of credit once it’s fully drawn.
Advantages:
- More structured repayment terms, making it easier to plan for full repayment.
- Typically used for one-time purchases or specific projects.
Disadvantages:
- Lack of flexibility, as you cannot reuse the credit once it’s repaid.
- May require reapplying for a new line of credit if additional funds are needed.
When Should You Use A Line of Credit?
A line of credit can be an excellent financial tool in a variety of situations, but it’s important to use it strategically. Here are some scenarios where leveraging a line of credit makes sense:
- Managing Variable Expenses
If you have irregular or seasonal expenses, such as medical bills, home repairs, or fluctuating business costs, a line of credit provides the flexibility to cover these expenses without borrowing a fixed amount upfront.
- Emergency Funds
A line of credit can serve as a safety net for unexpected emergencies, such as car repairs, medical emergencies, or urgent home improvements. It allows you to access funds quickly without depleting your savings.
- Financing Large Purchases
For large expenses that may be spread out over time, such as a home renovation or a wedding, a line of credit offers the flexibility to borrow as needed, rather than taking out a lump-sum loan.
- Business Cash Flow Management
Businesses can use lines of credit to smooth out cash flow during slow periods, cover payroll, or purchase inventory. A business line of credit provides access to capital when you need it most without requiring a long-term loan.
How To Use A Line of Credit Wisely
While lines of credit offer many benefits, it’s important to use them wisely to avoid falling into debt. Here are some tips for responsible use:
- Borrow Only What You Need: Just because you have access to a large credit limit doesn’t mean you should use it all. Borrow only what you need and can reasonably repay.
- Make Payments on Time: Late payments can damage your credit score and lead to additional fees. Be sure to make at least the minimum payment on time each month.
- Have a Repayment Plan: Before borrowing, have a clear plan for how you’ll repay the amount, especially if you’re using the line of credit for a large purchase or project.
Conclusion
A line of credit is a flexible financial tool that can provide individuals and businesses with the cash flow needed to manage various expenses, finance large purchases, or handle emergencies. Understanding the differences between revolving and non-revolving lines of credit, and knowing when to use them, can help you make informed financial decisions.
At Heritage Financial Credit Union (HFCU), we offer a variety of lines of credit tailored to your specific financial needs. Whether you’re looking for a personal line of credit, a HELOC, or a business line of credit, our team is here to help you navigate the process and make the best choice for your financial situation.