What Is a Personal Line of Credit and How It Works
Learn all about personal lines of credit: what they are, how they function, and how to apply and use them wisely.
A personal line of credit is a revolving credit product provided by financial institutions. It allows individuals to access funds as needed, up to a predetermined credit limit, providing financial flexibility. This financial tool offers access to funds on an ongoing basis, rather than as a single, upfront disbursement.
Understanding Personal Lines of Credit
A personal line of credit operates on a revolving basis, similar to a credit card. Funds can be borrowed, repaid, and then re-borrowed multiple times, as long as the total outstanding balance does not exceed the established credit limit. As the borrowed amount is paid down, the available credit replenishes, allowing for continued access to funds.
Interest rates for personal lines of credit are variable. These rates are tied to an economic index, such as the prime rate, plus a margin determined by the lender based on the borrower’s creditworthiness. Changes in the underlying index will cause the interest rate on the outstanding balance to adjust.
A personal line of credit involves two distinct phases: the draw period and the repayment period. During the draw period, which can last for several years, borrowers can access funds and are often required to make interest-only payments on the outstanding balance.
Following the draw period, the line of credit transitions into the repayment period. In this phase, the borrower can no longer draw new funds and must begin repaying both the principal balance and any accrued interest. Payments during the repayment period are fixed monthly installments designed to amortize the outstanding balance over a set term.
A personal line of credit differs from a traditional personal loan, which provides a lump sum of money upfront. With a personal loan, the borrower receives the entire amount at once and begins repaying it immediately through fixed monthly installments over a set term. In contrast, a line of credit offers flexible access to funds up to a limit, without an upfront disbursement.
Compared to many credit cards, personal lines of credit come with lower interest rates and may offer higher credit limits. While credit cards are also revolving credit, personal lines of credit are used for larger, less frequent financial needs, offering a more cost-effective option for substantial borrowing.
Applying for a Personal Line of Credit
Lenders assess factors when evaluating an application for a personal line of credit. A strong credit score is a primary consideration, with applicants needing good to excellent credit (a FICO score of 670 or higher). A higher credit score indicates a lower risk to the lender and may result in more favorable terms, such as a lower interest rate or a higher credit limit.
Income stability is another eligibility criterion. Lenders review the applicant’s current employment status and consistent income history. They also examine the applicant’s debt-to-income (DTI) ratio, which compares monthly debt payments to gross monthly income.
To complete an application, individuals need to gather documentation. This includes a valid government-issued identification, such as a driver’s license or passport. Proof of income is required, which may involve submitting recent pay stubs covering several months or tax returns from the past one to two years for self-employed individuals.
Lenders may request recent bank statements covering two to three months to verify financial activity and account balances. Proof of residency, such as a utility bill or lease agreement, may be necessary to confirm the applicant’s address.
The application process begins with submitting a formal application, either online or in person, to a financial institution. Many lenders offer a pre-qualification option, which allows applicants to see potential terms without a hard credit inquiry. After pre-qualification, a full application involves a hard credit check, which can temporarily affect the credit score.
The lender then reviews all provided information, including credit reports and financial documents, to make a lending decision. This evaluation determines the approval status, the credit limit, and the interest rate offered.
Using and Managing a Personal Line of Credit
Once a personal line of credit has been approved, funds can be accessed through various methods. Common ways include initiating online transfers directly to a linked checking account. Some lenders also issue checks that can be written against the line of credit, similar to a checking account.
A debit card may be linked to the personal line of credit, allowing for direct withdrawals from ATMs or purchases at point-of-sale terminals. The specific methods available for drawing funds will depend on the lender and the terms of the credit agreement.
Making payments on a personal line of credit involves minimum monthly payment requirements. During the draw period, borrowers are often required to make interest-only payments on the outstanding balance. Once the repayment period begins, payments will include both principal and interest, designed to pay off the balance over a set term.
Paying more than the minimum required payment, especially during the draw period, can significantly reduce the total interest paid over the life of the line of credit. This also helps to pay down the principal balance faster, freeing up more available credit for future needs. Consistent and timely payments are essential for maintaining a good financial standing.
Responsible management of a personal line of credit involves monitoring the outstanding balance and available credit. Regularly checking the account shows how much has been used and how much remains accessible. Understanding variable interest rate fluctuations is important, as changes in the market index can impact monthly payment amounts.
Avoiding over-leveraging is a strategy, meaning borrowers should not draw more funds than they can comfortably repay. Establishing a budget that incorporates the personal line of credit payments helps ensure funds are available when due. This helps prevent financial strain and maintains the utility of the credit line.
Borrowers should be aware of fees associated with personal lines of credit. Some lenders may charge an annual fee, ranging from $25 to $50, for maintaining the account. Draw fees, if applicable, may be charged each time funds are accessed, while late payment fees fall between $30 and $40.