How Does a Line of Credit Work and when is It Useful?

A line of credit is an agreement between a customer and a lending financial institution to establish the maximum amount of money which the lender can extend to a customer.  In this case, the customer can withdraw the allocated money up to a certain amount and he/she is required to be paying back the interest for a given period of time. Unlike the loan whereby a person is given a lump sum of money at once and starts to pay the interest instantly, in the line of credit, you will only be required to pay the interest after you have actually borrowed the money not after it has been made available to you.  

Therefore, in this article, we are going to enlighten you about how the line of credit works, when it is useful to obtain, and when it is not useful to have it as well.

How credit line works

Basically, there are two types of credit lines: personal and business credit lines. in both of these categories,  the procedure of application is less the same but the latter requires collateral in most instances although this might vary from one financial institution to another.  However, better credit scores will influence the annual percentage rate attached to both categories of the credit lines. After qualifying for the loan, a customer will have a certain set period in which they can withdraw the money from the account.

This period is well known as the “draw period” and it can last for many years which of course will also depend by the institution of concern.  In order to draw the money, the bank or any other financial lender will provide various alternatives such as the transfer of the money to your regular account, writing of cheque, or be issued with a card to use.

Once the customer borrows money from the line of credit, the interest starts to accrue immediately and therefore payments have to be started as per the lending agreement. The money paid back is always made available to the line of credit and this, therefore, means that a customer will always have a chance to borrow more depending on his/her nature of repayment.  Once the draw period comes to an end, the customers enter a repayment phase whereby they are supposed to clear the remaining balance within a given timeframe.

If the balance is not repaid during this period, further interest or penalties might apply depending on the initial terms and conditions of the agreement.

When it is useful

Generally, you can go for the line of credit under the following  circumstances:

  • If you are in need of loan on a consistent basis:   for startups and other small businesses, there is the need to have a constant flow of capital so as to boost the daily operational expenses. This can be made possible by acquiring loans more frequently but of course with a solid plan on how to repay them.  In such a case, going for the line of credit is the better option because you can always access the funds without having to always go through the long procedure of filling loan forms. Furthermore, it will not be economical for a person to take a loan every month in a bank and still repaying within the same timeframe and repeating the same cycle over again.
  • If you want to clear another debt which has a higher annual percentage rate:  at a personal or business level, you might have taken aloan which had a higher interest rate than the one associated with the line of credit.  In such a case, a person can acquire a line of credit in order to service the high APR loan with the focus of reducing the overall amount of money to be paid back as the interest. This is an economical move and it can save the borrower a lot of money both in short and long-term perspective.
  • if you have a relatively huge project at your home such as remodeling and maybe re-designing of your house, you can probably consider going for the line of credit provided that you have the means to service the credit afterward.