What Is a Line of Credit and How Does It Work?
6 Min Read | Last updated: September 13, 2024
This article contains general information and is not intended to provide information that is specific to American Express products and services. Similar products and services offered by different companies will have different features and you should always read about product details before acquiring any financial product.
A personal line of credit might be an effective way to manage temporary cash-flow problems. Learn what a line of credit is and what to know before applying for one.
At-A-Glance
- A personal line of credit may offer quick access to cash, but it has potential downsides, too.
- You might be able to obtain a high credit limit, but it might be harder to qualify for a line of credit than other lending options.
- Line of credit interest rates can be half as much as the average rate charged on credit cards, but there’s often no grace period.
Life sometimes throws a temporary cash-flow curveball our way that makes it hard to stay on top of promptly paying bills. That copay for medical tests to check out a knee hurt in a pickup game. The HVAC that conks out right when the tuition bills are due. Or, as anyone new to the gig economy may be learning in real time right about now: Those first paychecks may take time as clients add you to their payment system.
Being able to fall back on emergency savings or a credit card are common ways to cover temporary cash-flow crunches. A less well-known option is a personal line of credit.
What Is a Line of Credit?
By definition, a personal line of credit is a “revolving credit” account that you can tap into as needed to help cover short-term cash-flow problems. Much like a credit card, a line of credit comes with a maximum spending limit, and you’re charged interest only when you actually draw from the line of credit. You can continue to withdraw from the line of credit, up to your maximum limit, and any funds used must be repaid.1
How Does a Line of Credit Work?
Banks and credit unions have long offered businesses lines of credit to deal with cash-flow hiccups, such as when client payments aren’t coming in fast enough to cover business expenses.1 A personal line of credit delivers a similar financial bridge for households. Here’s how a line of credit works:
Application process. If the bank or credit union where you have a checking account offers a personal line of credit – not all do – you can usually apply online by answering a few questions. If your current bank or credit union doesn’t offer a personal line of credit, you can search online for options. However, you’ll usually need to open a checking account to be eligible for a personal line of credit.
Note that your application will trigger a hard credit inquiry, which may cause a temporary drop in your credit score.1
No collateral needed. Most personal lines of credit are “unsecured,” meaning you don’t need to pledge an asset as payment if you can’t repay what you tap.1,2 Instead, if you default, the account may be turned over to a collections agency. This differs from a home equity line of credit (HELOC), for example, where your home equity is the collateral: Missing too many payments could result in foreclosure.
Preset spending limits. If you’re approved for a line of credit, your preset limit will depend on factors such as credit score, income, and any existing debts in repayment.2 Credit lines typically max out around $100,000, but the exact amount will depend on the lender and your personal financial circumstances.1 When you repay any used portion, your available credit limit will be replenished by that amount.
When you open a line of credit, its credit limit is added to your total available credit limit – potentially benefiting your credit utilization ratio. But remember: Anytime you tap into your line of credit, it will cause your credit utilization percentage to rise. As a general rule, it’s smart to keep your credit utilization ratio below 30%.1
Good credit matters. Because this is an unsecured loan, the lender needs assurance that you’re highly likely to pay back what you use. Depending on the lender, you will need a specific FICO credit score to qualify for a personal line of credit. And the higher your credit score, the lower the interest rate will likely be.
The interest rate is variable. Most personal lines of credit charge an interest rate that might move higher or lower, based on changes in an underlying benchmark index. That’s the same way credit cards work. However, line of credit interest rates have been historically lower than those for credit cards.2
Things to Check Before Taking Out a Line of Credit
There are no uniform rules for how a line of credit may work – it depends on the lender. Before you sign on, consider the following key questions:
How long will the line be available? Some lines of credit allow you to tap into the money for a set number of years, such as five or more. This is known as the draw period. After that, you will be required to pay back any borrowed amount within a set time limit – such as another five or more years.1 Other lines of credit have no set draw period.
What’s the minimum monthly payment? Once you tap into the line, you’re required to start making payments immediately. It may be a set percentage, such as 2.5% of the used amount, or a minimum dollar amount of $25 or more.
When does the interest payment start? Lenders may start charging interest immediately, once you tap into a personal line of credit. Even if you are using the line for just a week or two while you wait for your next paycheck, you would still be charged interest. This differs from credit cards, which usually offer a “grace period” of around 30 days between the end of your billing cycle and when the payment is due, during which time no interest is charged.3 Using a credit card may make more sense, especially if you anticipate you can pay the entire balance when the bill is due.
Is there a fee? Some lenders might charge a monthly or annual fee.1 In some cases, you may have to pay this fee regardless of whether you’re using funds. Other lenders might only charge a fee if the funds are sitting unused.
Line of Credit Best Practices
A personal line of credit may be a valuable option to have at the ready for those occasional times when you find yourself in a short-term cash crunch. If possible, set up autopay to make sure you are always on time with payments. After all, your track record for making timely payments on all bills – credit cards, lines of credit, loans, etc. – accounts for 35% of your FICO credit score.1
Despite the benefits, it may be wise to avoid habitually relying on a line of credit – particularly if there isn’t an interest-free grace period. A credit card may be a better option.
Otherwise, if you find you constantly need to tap into your line of credit, it might be a sign to take a fresh look at your budget to see if there are ways to improve your cash flow. Ideally, you want to be able to save, not just pay the bills. Having money you can set aside to build up an emergency savings fund is the best way to be prepared when you run into a cash-flow jam.
The Takeaway
A personal line of credit might just be a smart way to be prepared for those times when your checking account is too low to cover all the bills. The interest charged on a line of credit may be lower than what you’ll be charged if you run up an unpaid credit card balance. But a personal line of credit typically requires a good or very good credit score, and there may not be a grace period on interest charges.
1 “What Is a Line of Credit?,” Experian
2 “How to Increase Your Chances of Getting Approved for New Credit,” Experian
3 “What Is a Grace Period?,” Experian
Carla Fried is a freelance journalist who has spent her entire career specializing in personal finance. Her work has appeared in The New York Times, Money, CNBC.com, and Consumer Reports, among many other media outlets.
All Credit Intel content is written by freelance authors and commissioned and paid for by American Express.
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The material made available for you on this website, Credit Intel, is for informational purposes only and intended for U.S. residents and is not intended to provide legal, tax or financial advice. If you have questions, please consult your own professional legal, tax and financial advisors.
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