What is a personal line of credit and how does it work?
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A personal line of credit can help you cover unexpected expenses, emergency repairs or temporarily fill cash flow gaps. It’s a debt product that gives you access to a pool of funds that you can borrow from any time you need cash.
Similar to a credit card, you can draw from a personal line of credit and repay the funds during what’s referred to as the draw period. When it ends, you’re no longer allowed to make withdrawals and would need to reapply to keep the personal line of credit open.
What is a personal line of credit (PLOC)?
A personal line of credit (PLOC) is an unsecured revolving account with a variable interest rate. It’s a type of loan you can draw from as needed and pay back with interest, much like a credit card. It can be a viable option to help manage your daily cash flow, especially if you have an irregular income or are faced with an unexpected expense.
PLOCs generally have lower interest rates than credit cards, so they’re typically cheaper for big cash advances. However, because PLOCs are unsecured, they’re best for consumers with a strong credit history. This means that a PLOC might not be the best option for everyone.
“You generally need good credit to qualify for a PLOC (say, 680-plus on the FICO scale) because this is unsecured credit,” said Ted Rossman, industry analyst at CreditCards.com. “You’re not putting your home, car or any other collateral on the line.”
How does a personal line of credit work?
A personal line of credit operates much like a credit card.
“You would go and apply for a line of credit in whatever amount you need, but you don’t walk out of the bank with a check,” said Adam Marlowe, principal market development officer for Georgia’s Own Credit Union. “You access the money as you need to use it, and your repayment is based on what you’ve used.”
Once approved for a PLOC, you can access funds via a revolving line of credit. That money can be tapped in various ways, such as withdrawing it at a lending institution’s local branches or initiating a transfer via a mobile app. Every draw will have to be repaid with interest, which is variable — meaning your interest rate will rise and fall based on market fluctuations.
It’s also important to note that most PLOCs have an expiration date.
“For instance, if you need a $3,000 line of credit, we’ll grant that line of credit and it’s good for two years,” said Marlowe. “You have an open revolving line of credit for $3,000 for two years.”
During that time, you can keep borrowing from and repaying the line of credit up to the line’s limit. But at the end of two years, you’d have to reapply with the lending institution to continue to maintain the line of credit.
Personal lines of credit vs. personal loans
Like a personal line of credit, a personal loan is an unsecured debt product that lets you access cash you need. Both require you to undergo a hard credit check to get approved, and the eligibility guidelines are generally the same. You can also expect to pay interest on the funds you borrow. But there are some key differences between the two to be aware of.
For starters, when you’re approved for a personal loan, you’ll receive the proceeds in a lump-sum and pay in monthly installments over a set period. So, you’ll be responsible for interest on the total loan amount.
You should also know that the interest rate on personal loans is fixed and often lower than you’ll get with a personal line of credit since it’s less risky. So, you’ll get a predictable monthly payment that’s easier to work into your budget.
Types of lines of credit
There are multiple types of lines of credit (LOCs). A personal line of credit is just one type. Each type of LOC has its own set of pros and cons. Evaluating your situation and the characteristics of each type of LOC will help you determine which kind is best for you.
Personal lines of credit
If you have some unexpected personal expenses to cover in a short period but no collateral (like a house or a car), a PLOC could be the best option for you. PLOCs are typically granted to individuals with good or excellent credit history since a lender is taking your word that you will pay back what you borrow with this type of LOC.
Business lines of credit
A business line of credit and a personal line of credit are functionally the same — you’ll receive a credit limit, which you can draw up to and pay back as needed. However, business lines of credit may have higher limits and are designed specifically for businesses. A business may use a line of credit for equipment purchases, short-term cash flow issues and more.
Home equity lines of credit (HELOCs)
A home equity line of credit uses the equity you’ve built up in your home to determine your borrowing amount. Unlike personal lines of credit, these loans are secured — meaning your home is used as collateral for the loan, and failing to repay the loan could put your home at risk of foreclosure. However, because you take on more risk with this type of borrowing, interest rates are often much lower.
Types of repayment for a personal line of credit
Personal lines of credit are only temporary. When you apply for one, you will usually be given a specific period for when you may withdraw funds, called a draw period. You will enter a repayment period if you still have an unpaid balance on your personal line of credit when the draw period ends.
You will have to pay off any remaining balance during the repayment period. However, different lenders may have different terms for repayment. The various types of repayment may include the following:
- Draw and repayment periods: This is the most common type of repayment used for a PLOC as described above. Typically, monthly payments are required during the repayment period.
- Balloon payments: This type of repayment requires that the full balance is paid at the end of the draw period.
- Demand line of credit: While not very common, some lenders may set up a PLOC as a demand line of credit. This means the lender has the right to ask for full repayment at any time.
When setting up your personal line of credit, ensure you understand your lender’s repayment terms. Be sure to make a repayment plan.
Pros and cons of personal lines of credit
A personal line of credit has several advantages compared to other fast capital sources, but it’s not the right choice for everyone. Consider both the benefits and drawbacks before applying.
Pros of personal lines of credit
- Quick access to funds: With a personal line of credit, you can borrow money anytime during your draw period. You can access the line of credit through your bank branch, online, or with a mobile app depending on your lender.
- Overdraft protection on some accounts: If you are worried about overdrafting an account, some banks will let you use a PLOC as overdraft protection. This can offer you security if you often write checks or worry about overdrafting your account.
- Competitive rates compared to credit cards: A personal line of credit typically has lower interest rates than a credit card. Although, the rate on your PLOC will vary depending on your lender and your personal credit history.
- No collateral required: While other options like home equity lines of credit use your home equity as collateral, a PLOC does not require any collateral. So, this can be a great option if you don’t have a home or a car to use as collateral.
- Only pay for the draws that you make: With a PLOC, you don’t have to pay anything until you make a draw on your funds. You can withdraw funds of any amount within your limit and you only pay for the amount you have withdrawn plus interest.
Cons of personal lines of credit
- Higher rates than HELOCs: A HELOC is considered a secured line of credit since your home is used as collateral for the amount you owe. But, a PLOC is considered unsecured since it does not have collateral. This means the interest rates will likely be higher with a PLOC.
- Interest isn’t tax-deductible: You cannot deduct the interest on a line of credit from your taxes. This adds an extra cost to opening a PLOC.
- Hard to qualify with poor credit and/or limited credit history: Without any collateral on a PLOC, the lender must take your word that you will pay back what you use. This means they are less likely to grant you a PLOC if you have poor credit history.
- Risk of over-borrowing: You can borrow up to your limit on your PLOC throughout the draw period. However, when the draw period ends, you must repay what you have used, plus any interest that has accrued. If you do not have a repayment plan, you can risk over-borrowing.
- Variable interest rates: Typically, a PLOC has a variable interest rate, so it is difficult to determine exactly how much interest you will end up paying.
How to find the best personal line of credit
You will need two primary things if you want to get a personal line of credit: a good credit score and solid credit history.
“You want to have the best credit you can have,” Dave Sullivan, credit expert with People Driven Credit Union, said. “If you have any revolving lines of credit, it’s best to pay those down as low as you can prior to applying, and make sure that info has been reported to the credit bureaus.”
And although a personal line of credit may have higher rates than something like a home equity line of credit (HELOC), the interest rates on PLOCs are usually much lower than those of a credit card cash advance or payday loan.
Check with multiple lenders to see who will give you the best terms. You will want to consider interest rates, repayment terms and the length of the draw period.
The application process for a PLOC is much the same as applying for any loan, and it can often be completed online. Once you’ve decided on a lender and the credit limit you’re seeking, you’ll need to provide information such as your name, Social Security number and employment and income details.
Where to get a personal line of credit
Personal lines of credit are available through traditional banks, credit unions and also online lenders. You can start by applying with the bank or financial institution where you have an existing relationship but may also want to shop around to ensure you get the best interest rate and terms for your financial needs.
If you’re interested in applying for a personal line of credit with a credit union, you may be required to become a credit union member first.
Alternatives to a personal line of credit
You may find that a personal line of credit isn’t a good fit after exploring your options. If so, consider a personal loan or these alternatives to access the cash you need:
- Credit cards: Balance transfer credit cards come with an interest-free period – typically between 12 and 21 months. So, you can get an interest-free loan assuming you pay the balance in full before the promotional APR window ends.
- Home equity loans: Home equity loans and home equity lines of credit (HELOCs) let you borrow against the equity you’ve built up in your home. You may be able to access a sizable amount of cash since most lenders let you borrow between 75 to 85 percent of your home equity.
- 401(k) loan: If you have a 401(k) retirement plan with your employer, you may be able to borrow against the balance. There are no stringent income and credit score guidelines, making it an easily accessible option. Plus, the interest you pay on the loan goes back to your retirement account.
The bottom line
Operating like a credit card, a personal line of credit can be opened for whatever amount of money you need and be used on a revolving basis. Borrowing money this way has many advantages, including providing quick access to cash and offering more competitive rates than credit cards.
But remember, this type of account may not be for everyone. You’ll need a solid credit history to qualify and there’s a risk of overborrowing if you don’t have a history of using credit responsibly. If you choose to open a personal line of credit, shop around and find the best interest rate and terms for your financial needs.