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A personal line of credit is a type of revolving credit that can be used to cover expenses like home renovations. Here’s what you need to know before applying. (iStock)
When you need access to funds fast, you may have multiple ways to get the money you need. Personal loans are one option — they let you borrow a set amount of money in one lump sum.
A personal line of credit is another way to get money quickly, and it functions more like a credit card. Here’s what you need to know before getting started with a line of credit.
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- What is a personal line of credit and how does it work?
- Pros of a personal line of credit
- Cons of a personal line of credit
- How to apply for a personal line of credit
- How to repay a personal line of credit
- When to take out a personal loan
- When to take out a personal line of credit
What is a personal line of credit and how does it work?
As the name suggests, personal lines of credit are used mainly for covering personal expenses like education costs, car repairs, or medical debts. Of course, these are also uses for a personal loan.
But with a personal loan, you receive a lump sum of money that you repay in fixed, monthly installments. A personal line of credit allows you to withdraw money as needed — up to the approved spending limit — during a specified drawing period, which is typically a number of years. As you make withdrawals, your available balance (the amount you can withdraw) reduces. You can restore your available balance by repaying the amount you owe. This is why a personal line of credit is considered a revolving line of credit, like a credit card.
Interest only accrues on the money you borrow — not on any balance you haven’t taken out of the account. But it begins accruing immediately, as soon as you borrow the money.
After your draw period is over, you’ll enter the "repayment period," when you’ll have a set number of months in which to pay off any outstanding balance. And, as with a credit card, if you only make the minimum monthly payments required, it can take much longer to pay off your balance.
Similar to personal loans, personal lines of credit are usually unsecured, which means they’re not attached to any form of collateral that can be repossessed if you default on your financial obligation.
A personal line of credit can be a good option if you need flexibility in terms of borrowing and repaying. Or, you may choose an unsecured personal line of credit if you’re unsure of exactly how much you need.
Pros of a personal line of credit
A personal line of credit has some advantages over other types of unsecured credit.
- Flexibility — You can borrow only as much as you need, when you need it.
- Revolving — If you pay down your balance, you can use the line of credit again to cover a different expense until you reach the end of your draw period.
- Unsecured — A personal line of credit is typically an unsecured loan, which means you don’t need to use collateral like your home or a savings account to take one out, and you won’t lose an asset if you default on the loan.
Cons of a personal line of credit
It’s also important to consider the disadvantages of a personal line of credit.
- Potentially high, variable interest rates — While personal lines of credit typically offer lower interest rates than a credit card, they’re usually higher than personal loan rates. Generally, interest rates for personal lines of credit are variable, which can make your monthly payments unpredictable. Of course, your credit history will play a role in determining the rate you actually receive.
- Fees — Many lines of credit come with fees, including an annual fee and, usually, a fee for overdrafts.
- Risk of overspending — Having a line of credit at your disposal can make it tempting to spend money and put yourself further in debt.
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How to apply for a personal line of credit
You’ll typically need a strong credit score to qualify for a personal line of credit. Since these financial vehicles are unsecured, they present a greater risk for the lender. As a result, lenders often want reassurance that you have a decent repayment history and stable income.
In addition to filling out a few forms, you’ll also need to submit to a credit check, and provide proof of income as part of the application process.
It’s worth noting that if you’re approved for one, opening a personal line of credit may actually help your credit score. For one, it can help lower your credit utilization rate, which is the measure of how much credit you're using versus how much is available to you. And making payments on time could help to strengthen your overall payment history.
How to repay a personal line of credit
Repaying a personal line of credit depends on which terms you and your lender agree on. In general, you can repay the line of credit in one of three ways:
- Draw and repayment periods — This is the most common way to repay a personal line of credit. You borrow money as needed during your draw period and only pay interest on the amount that you’ve borrowed. Then, during the repayment period, you’ll be responsible for making payments on both the interest and the remaining principal balance.
- Balloon payments — With balloon payments, you’ll make periodic payments on the accrued interest. Then, after a set period of time, your full principal amount will become due in one lump sum payment.
- Demand line of credit — With a demand line of credit, the lender reserves the right to call the full balance due at any time.
When to take out a personal loan
Personal loans and personal lines of credit have some significant similarities — and differences. A personal loan can be a better choice over a personal line of credit if you know how much you intend to spend. Since the funds from personal loans are distributed in one lump sum, they often make sense for one-time purchases, such as covering medical bills or consolidating debts.
If you have a good idea of how much you need, personal loans are often easier to repay as well. Typically, they come with fixed interest rates and installment payments on a set repayment schedule. The closed-end nature of a personal loan also may make it easier to incorporate into a budget.
Credible makes it easy to check personal loan rates from multiple lenders.
When to take out a personal line of credit
In some situations, however, a personal line of credit may be a better fit for you. If you’re trying to manage ongoing costs, it may make more sense to take out a personal line of credit, since it allows you to borrow money as needed.
Many people use personal lines of credit for ongoing expenses, such as home renovations or education costs.