What Is a Line of Credit? How It Works and When To Use One 

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A line of credit is an amount of money you can borrow from a bank or credit union on an ongoing basis. You can pay it back and reborrow it at any time. But it does typically come with some unique terms you should know about.

How Does a Line of Credit Work?

A line of credit is a type of loan, but unlike a traditional installment loan where you receive a lump sum upfront and repay it in fixed installments, it works more like a revolving credit account, similar to a credit card. You can borrow up to the amount of your credit limit, and then you’ll have to pay down your debt before you can borrow money again.

You only pay interest on the amount of your credit line that you use. However, you’ll begin accruing interest immediately. To minimize fees, you should pay back your debt as quickly as possible.

Draw Period

A line of credit often comes with something called a “draw period,” which usually lasts several years. This is the period in which you can borrow from your credit limit.

As with most lines of credit, this period ends and you’re obligated to pay back the money you owe. You’ll either be put on monthly installments or have to pay your balance back all at once.

What Are the Pros and Cons of a Line of Credit?

Types of Lines of Credit: 3 Examples

Here’s a quick look at some examples of lines of credit you’ll commonly see.

1. Personal Line of Credit 

A personal line of credit (PLOC) is a personal loan that is usually unsecured, meaning you don’t need collateral to open an account.

Personal lines of credit are great when you’ve got large expenses that you probably can’t pay off within a month or two. Interest rates are often lower than credit cards, so you’ll likely save on fees when using a PLOC instead of a card. Think expenses like home repairs and medical bills.

PLOCs are best for those with good credit who want flexible, ongoing access to funds.

2. Home Equity Line of Credit (HELOC)

A home equity line of credit is a revolving loan secured by your home’s equity. You’ll often receive lower interest rates — and potentially a higher credit limit — depending on the amount of equity you have in your home, but with the added risk of losing your home if you default on your loan.

That all said, a HELOC is a high-risk line of credit that you shouldn’t consider unless you’re confident you can repay what you borrow.

Of course, you shouldn’t ever take a loan out if you suspect you can’t pay it back. HELOCs are great for homeowners looking for lower-interest borrowing options.

3. Business Line of Credit

Businesses routinely need to float money month-to-month to cover expenses like inventory and payroll. Sometimes it requires selling product to pay off those expenses. A business line of credit (BLOC) is a common way to temporarily cover business expenses.

A business line of credit is perfect for small business owners needing ongoing access to working capital.

This table can help you decide which type of credit line is best for your situation.

Line of Credit vs. Other Loans

A line of credit is just one of the many types of loans a bank may offer you. There are important differences to know about — and unique times that each comes in handy. For example:

Credit Card

If you only want a line of credit to make everyday purchases, a credit card is a good option. There’s no finite “draw period,” so you can continue to borrow for as long as the card is active.

Keep in Mind

Credit card interest rates tend to be extremely high, so this isn’t a good option for big purchases that you can’t pay off within a month.

Installment Loan

If you don’t need to borrow money on a continual basis and you simply want a lump sum of cash for an upcoming expense, an installment loan may be your preference.

For those with good credit, interest rates can be significantly lower than other loan types. With a fixed payment plan, you’ll have a clear idea as to when your loan will be paid off.

Auto Loan

If you’re looking to buy a car, an auto loan is often far cheaper than a line of credit. It’s a type of installment loan with extremely low APR — even below 5% for those with respectable credit.

Payday Loan

If you can help it — never open a payday loan. They often come with predatory interest rates — over 400% in some cases — and unforgiving repayment terms that can trap you into a debt cycle. You may need a quick buck for an emergency, but only do this after your last resort fails you.

When Is a Line of Credit a Good Fit?

A line of credit is a good fit if you’ve got ongoing large expenses that you can’t pay off within a month or two.

A line of credit helps you fund expenses as they arise. However, relying too much on your line of credit can lead to excessive interest fees and a tendency to overspend.

For example, if you’re installing a pool in your backyard, you use a line of credit to fund it in phases. You may spend a few thousand dollars on excavation, then several thousand on installation of the pool shell. After that, you may pay for plumbing and electrical, followed by a patio and landscaping.

If you use a line of credit wisely, you’ll have a way to handle your finances efficiently. Just remember to never borrow more than what you can manage.

Karen Doyle contributed to the reporting for this article.

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