Lines of credit: What they are & how they work

A line of credit is a type of credit account that works much like a credit card does. It allows a borrower to withdraw money and repay it over and over again as long as the account is open and in good standing.

But how does a line of credit work? And when can one be useful? Use this guide to learn more.

What you’ll learn:

• Lines of credit are typically considered revolving accounts and may work like credit cards. But there are some nonrevolving lines of credit.

• Lines of credit can be unsecured or secured, depending on whether collateral is required.

• Examples include personal lines of credit (PLOCs), home equity lines of credit (HELOCs) and business lines of credit.

• Like many loans, the application process for a line of credit is typically based on a borrower’s creditworthiness.

A line of credit is a type of loan where you have access to a preset credit limit to use and then repay again and again. Because lines of credit are open-ended debt, they don’t have a defined payoff date. They’re available to the account holder as long as the account is in good standing.

Lines of credit are typically available at financial institutions, such as banks and credit unions.

A line of credit may work differently depending on the terms and conditions of the account. But they often work similarly to credit cards in that:

• You have access to a credit limit. Your credit limit determines how much money you’re allowed to borrow from a line of credit. 

• You make monthly payments. Many lines of credit have minimum monetary amounts you’re required to pay monthly. 

• You pay interest on outstanding balances. Lines of credit will usually charge interest, either at a fixed or variable rate.

Lines of credit can be either revolving accounts or nonrevolving accounts. 

With a revolving line of credit, a person can borrow money and then make payments on an ongoing basis as long as they don’t exceed the account’s credit limit. As they use the line of credit, the amount of available credit goes down. As they pay it back, the available credit goes back up.

Nonrevolving lines of credit are similar to revolving lines of credit in the sense that there are funds available to the borrower. But the difference is that once the money is used and paid back, nonrevolving accounts are typically closed and can no longer be used.

Lines of credit can be secured or unsecured accounts.

With a secured line of credit, you provide collateral to back the loan. If you don’t repay the funds, the lender can take the assets that were used as collateral. 

Unsecured lines of credit don’t require collateral. For this reason, they may have higher interest rates than secured lines of credit do.

Here are common types of credit lines, plus requirements borrowers may need to satisfy for each:

Personal lines of credit (PLOCs) are typically unsecured, revolving loans that are taken out for personal use. A PLOC might be used in ways similar to a credit card, like handling bills and other expenses. Terms for a PLOC vary depending on the lender. And to approve a line of credit, lenders often require a strong credit history and an open checking account.

Home equity lines of credit (HELOCs) are a common type of secured credit account. With this loan, a borrower can draw money against the equity they have in their home. 

When applying for a HELOC, lenders typically request an appraisal to assess the home’s value. From there, the lender will determine the credit limit, which is usually 75% to 80% of the home’s market value. 

If you’re approved for a HELOC, you can draw against your home’s equity during what’s known as a draw period. Draw periods vary depending on the agreement, but 10 years is a common time frame. During the draw period, you can access and repay funds over and over again as long as purchases stay within the limit.

Business lines of credit can be used by organizations to cover their operating costs and other business-related expenses. Depending on the agreement, they could be secured or unsecured. Collateral for secured business lines of credit could be:

• Property

• Equipment

• Inventory

• Investments

You can apply for a line of credit from lenders that offer them, including banks and credit unions. 

The application process may be similar to that of other loans or credit applications. Lenders generally review your creditworthiness to determine whether you’re eligible. And the higher your credit scores, the more likely you are to get a line of credit with lower interest rates. 

Before applying, weigh different options by comparing things like annual percentage rates (APRs). You can also look for fees and other costs related to opening the account.

Applying for, opening and using a line of credit may affect your credit scores in a number of ways. Here are a few major factors involved in credit scoring:

• Payment history

• Debt

• Credit age

• Credit mix

• New credit applications

If it’s a revolving line of credit, your credit utilization ratio might also be affected. But how exactly a line of credit affects your scores depends on the credit-scoring model and when your scores are calculated.

Lines of credit can be used to help cover a variety of expenses, including those that are unexpected or are part of an ongoing project. For example, they may help fund a wedding or cover a home renovation. But whether a line of credit is a good option comes down to a borrower’s individual circumstances. 

As with any loan, it may help to research lines of credit before you apply for one. For example, you may want to fully understand the terms of the loan and have a plan for how it might fit into your budget.

There are different kinds of credit lines, including revolving and nonrevolving accounts. But in general, they can offer flexible funding options for large or unexpected expenses.

Similar to a line of credit, a credit card can offer flexible access to funds. Some credit cards can also offer advantages over a line of credit, like rewards. Learn more about Capital One cards or see whether you’re pre-approved with no impact to your credit.

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