What Is a Line of Credit (LOC) in Finance?

A Line of Credit (LOC) is a financial tool offered by banks and other lending institutions. It provides a flexible approach to borrowing, unlike a traditional lump-sum loan. This arrangement gives individuals or businesses access to a predetermined amount of money they can draw upon as needed.

Understanding a Line of Credit

A Line of Credit is a revolving credit facility, allowing funds to be borrowed, repaid, and re-borrowed up to a specified credit limit. This differs from an installment loan, where a fixed amount is received upfront and repaid over a set period through regular, typically equal, monthly payments. With an LOC, the borrower only incurs interest on the amount actually used, not the entire available credit limit.

It offers flexibility in accessing funds. As funds are repaid, the available credit replenishes, allowing for continued use without needing to reapply. Lenders establish the credit limit based on the borrower’s creditworthiness and financial standing. This structure makes an LOC suitable for ongoing or unpredictable expenses, contrasting with the fixed nature of a traditional loan, which is typically for a single, defined purpose.

Different Types of Lines of Credit

Lines of Credit are categorized based on whether they require collateral, influencing their terms and accessibility. Secured lines of credit require collateral, such as real estate or other assets, which helps reduce the lender’s risk and often results in lower interest rates. Unsecured lines of credit do not require collateral, but typically come with higher interest rates due to the increased risk for the lender.

A personal line of credit (PLOC) is typically unsecured and for individual needs. It provides flexible funding for personal expenses like managing cash flow, covering unexpected costs, or consolidating higher-interest debt. They are often used when the exact amount of funds needed is uncertain, offering an alternative to credit cards with potentially lower interest rates and higher limits.

Businesses use lines of credit to support operations and manage working capital. A business line of credit can be secured by assets like accounts receivable or inventory, or it can be unsecured. This type of LOC helps cover day-to-day operating expenses, bridge cash flow gaps, and finance short-term projects or seasonal needs.

A Home Equity Line of Credit (HELOC) is a secured LOC that uses home equity as collateral. Borrowers can access funds up to a certain percentage of their home’s value, typically 75% to 85% after accounting for any outstanding mortgage. HELOCs are commonly used for home improvements, debt consolidation, or other significant expenses, often featuring lower interest rates than unsecured options because they are backed by the home.

How a Line of Credit Operates

Accessing funds from an LOC is convenient. Borrowers can draw money through various methods, including writing checks, electronic transfers to a checking account, or using a debit card linked to the line. Some business LOCs may also allow for direct cash withdrawals.

Interest on an LOC is calculated only on the outstanding balance, not the entire credit limit. Most Lines of Credit feature variable interest rates, which can fluctuate based on market conditions, such as changes in the prime rate. This contrasts with many traditional loans that have fixed interest rates throughout their term.

Repayment terms typically require minimum monthly payments, often covering accrued interest plus a small portion of the principal. However, borrowers have the option to pay more than the minimum to reduce their outstanding balance faster and lower overall interest costs. As payments are made, the available credit within the set limit is replenished, allowing the borrower to draw funds again without reapplication.

The credit limit defines the maximum amount that can be borrowed, and available credit fluctuates with draws and repayments. For instance, if a $10,000 LOC has $3,000 borrowed, $7,000 remains available. Repaying $1,000 would then increase the available credit back to $8,000. Lenders may also impose a “draw period,” typically a set number of years, during which funds can be accessed, followed by a repayment period where no new draws are allowed.

Practical Applications of Lines of Credit

Lines of Credit offer practical financial solutions for individuals and businesses. For individuals, an LOC can serve as a financial safety net for unexpected expenses like medical bills or car repairs, providing funds without needing a new loan each time. They can also be used for ongoing expenses with uncertain total costs, such as home renovations, especially with a HELOC. Bridging short-term cash flow gaps, particularly for those with irregular income, is another common personal application.

Businesses use lines of credit to manage working capital, covering day-to-day operational costs like payroll, inventory, or rent. This is particularly useful for businesses experiencing seasonal fluctuations in revenue, allowing them to maintain operations during slower periods and stock up for peak seasons. An LOC provides immediate access to capital for short-term projects or to seize new opportunities without committing to a long-term loan. It acts as a financial cushion, helping businesses navigate unforeseen expenses or temporary dips in cash flow.