Lines of credit: What they are & how they work

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

Learn more about different kinds of credit lines, how they work and how a line of credit might affect your credit scores.

What you’ll learn:

• Lines of credit are typically revolving accounts and may work similarly to 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 a borrower can use and then repay again and again up to a preset credit limit. Lines of credit are typically available at financial institutions, such as banks and credit unions. Some lines of credit are for personal use, while others are for business expenses.

There are several different types of lines of credit. And they may work differently depending on the terms and conditions of the account. 

Generally, a line of credit will have a set credit limit. The account holder can borrow and repay money up to that limit. Lenders typically set the credit limit based on the borrower’s creditworthiness. Lines of credit also usually charge interest, either at a fixed or variable rate. And many lines of credit require minimum monthly payments. 

You may be able to use your line of credit by writing special checks or requesting a transfer to your checking account. In some cases, the lender may also issue a card that’s connected to the account.

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.

When you borrow money from a nonrevolving line of credit, your available credit doesn’t go back up once you repay the debt. After you repay it, typically, the account will be closed. This kind of account is sometimes referred to as installment credit.

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. Unsecured lines of credit may also require higher credit scores.

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. Similar to a credit card, a PLOC might be used for things such as financing a large purchase or managing cash flow. 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 with the same financial institution.

Personal loans work differently, because they’re a type of installment loan. This means the borrower gets a lump sum up front. Then they pay it back in equal monthly payments over a set period of time.

Home equity lines of credit (HELOCs) are a common type of secured credit account. With this line of credit, 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 up to 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

As with any kind of loan or credit, there are some potential benefits and drawbacks of taking out a line of credit.

Some possible upsides of a line of credit may include:

• Convenient, flexible access to funds

• Relatively low interest rates 

• Options that don’t require collateral 

• May be used for overdraft protection

Lines of credit may have potential downsides to consider, including:

• Borrowers with low credit scores may have a hard time qualifying for some lines of credit. 

• Lines of credit may charge fees, including origination fees and maintenance fees. 

• Interest may not be tax deductible. 

• They may not provide the same protections as credit cards.

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 that may be affected by opening and using a line of credit:

• Payment history

• Debt

• Credit age

• Credit mix

• New credit applications

• Credit utilization 

Exactly how a line of credit affects your scores depends on the credit-scoring model and when your scores are calculated. Keep in mind that when you apply for any new credit account, it may trigger a hard inquiry. And hard inquiries may cause your credit score to drop temporarily.

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 with undefined costs. For example, they may help fund a wedding or cover a home renovation. But ultimately, it’s up to the borrower to decide how to use their line of credit. 

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 payments might fit into your budget.

Want to learn more about lines of credit? Here are answers to some frequently asked questions:

Lines of credit are one way to cover large or unexpected expenses. Before taking out a line of credit, make sure to look into things like fees, interest and how it will impact your budget.  

Credit cards are another way to get convenient, flexible access to funds. Some credit cards can also offer advantages, such as rewards, over a line of credit. 

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