How Does a Line of Credit Work: A Comprehensive Guide

A line of credit (LOC) is a flexible borrowing option that allows individuals and businesses to access funds up to a predetermined limit. Unlike traditional loans that provide a lump sum of money upfront, a line of credit enables borrowers to withdraw funds as needed, repay them, and borrow again. It is a valuable financial tool for managing cash flow, covering unexpected expenses, or financing specific projects.

Lines of credit can be secured or unsecured. Secured lines of credit require collateral, such as a home or savings account, reducing the lender's risk and often resulting in lower interest rates. Unsecured lines do not require collateral, but they typically come with higher interest rates due to the increased risk for lenders.

Understanding how lines of credit work is crucial for making informed financial decisions. This guide will delve into the various types of lines of credit, their advantages and disadvantages, application processes, and strategies for effective management. Whether you’re considering a line of credit for personal or business use, this comprehensive guide equips you with the knowledge to leverage this financial tool effectively.

What is a Line of Credit?

A business or personal line of credit (LOC) is a type of loan between a borrower and a lender that provides access to a specified amount of credit over a set period. Unlike a traditional loan, which disburses a fixed sum upfront, a line of credit allows you to borrow money repeatedly as needed, up to their credit limit. This flexibility makes it an appealing option for managing cash flow, covering unexpected expenses, or funding specific projects.

Key Features of a Line of Credit

1. Credit Limit: The maximum amount that you can borrow, established by the lender based on creditworthiness and income.

2. Flexible Withdrawals: Borrowers can withdraw money, repay it, and borrow again as needed, similar to a credit card. You only pay interest on the amount borrowed, not the entire credit limit.

3. Interest Rates: The variable interest rate fluctuates based on market conditions or the borrower’s credit profile. Secured lines of credit may offer lower interest rates because they are backed by collateral.

4. Repayment Terms: Lines of credit usually have a draw period during which borrowers can access funds, followed by a repayment period where the borrowed amount must be paid off. Some lenders may require minimum monthly payments.

5. Types: There are two main types of lines of credit:

   • Secured Line of Credit: Backed by collateral, such as a home or savings account, reducing risk for the lender.

   • Unsecured Line of Credit: Not backed by collateral, typically carrying higher interest rates due to increased risk.

Types of Lines of Credit

Lines of credit can be secured or unsecured. Each type has distinct characteristics, benefits, and risks associated with them.

Secured Line of Credit

A secured line of credit is backed by collateral, which can be any asset, such as a home, vehicle, or savings account. Borrowers reduce the lender's risk, potentially resulting in more favourable terms, such as lower interest rates and higher credit limits.

Unsecured Line of Credit

An unsecured line of credit does not require collateral, meaning borrowers do not need to pledge assets to access funds. However, because this type of line presents a higher risk for lenders, they usually impose stricter qualification criteria and higher interest rates.

Line of Credit Costs

Understanding the costs of a line of credit is essential for making informed financial decisions. While lines of credit can offer flexibility and convenience, they also come with various costs that borrowers should consider.

Interest Rates

• Variable Rates: Most lines of credit have variable interest rates that fluctuate based on market conditions, often tied to a benchmark rate like the prime rate. As interest rates rise or fall, so will the cost of borrowing.

• Fixed Rates: Some lenders may offer fixed-rate lines of credit, providing stability in payment amounts. However, these may be less common and have stricter eligibility requirements.

• Impact on Costs: The interest rate significantly affects the overall cost of borrowing. Higher rates will increase the total amount you pay over time, so shop around for competitive rates before committing.

Fees

• Annual Fees: Some lenders charge an annual fee for maintaining a line of credit. This fee can vary widely among lenders.

• Draw Fees: Certain lenders may impose a fee each time you withdraw funds from your line of credit. This can be a flat fee or a percentage of the amount drawn.

• Maintenance Fees: Some lines of credit may have monthly or quarterly maintenance fees that cover account servicing.

• Late Payment Fees: If you miss a payment or pay late, lenders typically charge a late payment fee, which can add to your overall costs and affect your credit score.

• Transaction Fees: If you use the line of credit to make purchases or transfers, transaction fees may apply, particularly if you use a credit card linked to your line of credit.

Repayment Penalties

• Early Repayment Fees: Although many lines of credit allow you to pay off the balance at any time without penalty, some lenders may impose a prepayment penalty for paying off the line of credit too early. It’s essential to review the terms carefully to avoid unexpected fees.

Impact on Credit Score

• Credit Utilization: Lines of credit impact your credit score based on your utilization ratio. High utilization can lower your credit score, potentially leading to higher borrowing costs in the future.

• Payment History: Timely payments contribute positively to your credit score, while late payments can impact your ability to secure favourable rates on future loans.

Eligibility and Application Process

Understanding the eligibility requirements and application process for a line of credit is essential for prospective borrowers.

Eligibility Criteria

• Credit Score: Most lenders require a minimum credit score for approval. Generally, a score of 650 or higher is favorable, though requirements may vary by lender. A higher credit score can lead to better interest rates and terms.

• Income Verification: Lenders assess your ability to repay the line of credit by examining your income. This may include your salary, bonuses, and any additional sources of income. A steady income demonstrates financial stability, which is crucial for approval.

• Debt-to-Income Ratio: Your debt-to-income (DTI) ratio measures how much of your income goes toward existing debts. Lenders typically prefer a DTI ratio below 40%. A lower DTI indicates a better ability to manage additional debt.

• Employment History: A stable employment history can positively influence your application. Lenders may look for consistent employment over the past few years as a sign of reliability.

• Collateral: Collateral, such as real estate or savings accounts, may be required to provide the lender with security in case of default.

• Debt-to-Equity Ratio: The debt-to-equity ratio measures your debt relative to your equity, indicating your financial leverage and ability to manage new debt. Lenders generally prefer a lower ratio, typically below 1.0, as it suggests you are not over-leveraged and can handle additional credit responsibly.

How to Repay Your Line of Credit

Repaying a line of credit involves several key steps to manage the debt effectively while minimizing interest costs and maintaining financial health.

1. Make Minimum Payments: Each billing cycle, you must make at least the minimum payment, which typically covers the interest charged. Staying on top of these payments helps you avoid penalties and keeps your account in good standing.

2. Pay More Than the Minimum: Paying more than the minimum is crucial for reducing your balance faster, as this reduces the principal and limits the amount of interest you pay over time. This strategy also helps free up more available credit.

3. Automate Payments: Setting up automatic payments ensures you never miss a due date, helping you avoid late fees and potential damage to your credit score. Automation also adds convenience and consistency to your repayment process.

4. Use Lump Sum Payments: Apply lump sum payments toward your line of credit whenever possible, such as a bonus, tax refund, or extra income, to reduce the balance and interest owed.

5. Monitor Your Spending: Regularly review your line of credit usage and payments to ensure you are not overspending or borrowing beyond what you can comfortably repay.

6. Refinance or Consolidate: If your line of credit has high interest rates, consider refinancing or consolidating the debt into a loan with lower interest, which could save you money over the long term.

Line of Credit Insurance

Line of credit insurance protects borrowers by covering payments if they cannot due to death, disability, or critical illness. It offers financial security by ensuring that outstanding balances or monthly payments are managed during difficult times.

Common coverage options include life insurance for the outstanding balance in case of the borrower's death, disability insurance for payments if the borrower cannot work due to injury or illness, and critical illness insurance if the borrower is diagnosed with a covered medical condition.

Credit Score Impact

A line of credit can significantly affect your credit score positively or negatively. Understanding how this financial tool interacts with your credit profile is essential for managing your financial health. Here's an overview of how a financial institution or lender calculates your credit score.

Credit Utilization Ratio

The credit utilization ratio is the percentage of your available credit that you are currently using. It is calculated by dividing your total outstanding credit balances by your total credit limits across all accounts.

Credit scoring models generally favour a lower credit utilization ratio. Your credit utilization increases if you use a significant portion of your line of credit, potentially lowering your credit score. Keeping your utilization below 30% is typically recommended to maintain a healthy credit score.

Payment History

Making on-time payments on your line of credit positively impacts your payment history, which is one of the most critical factors in determining your credit score. Consistent, timely payments can enhance your credit profile. Late payments can have a severe negative impact on your credit score. Even one missed payment can stay on your credit report for up to seven years.

Credit Mix

Credit scoring models often favour a diverse mix of credit accounts, including revolving accounts (like credit cards and lines of credit) and instalment loans (like mortgages, personal loans, and home equity loans). Having a line of credit can contribute positively to your credit mix, demonstrating your ability to manage different types of credit.

New Credit Inquiries

When you apply for a line of credit, the lender will perform a hard inquiry on your credit report to assess your creditworthiness. It can temporarily lower your credit score by a few points. However, the impact of hard inquiries diminishes over time and typically disappears within a year.

If you apply for several lines of credit in a short period, multiple hard inquiries can accumulate, which may negatively affect your score. It's advisable to space out credit applications to minimize this impact.

Account Age

The length of your credit history is another factor in your credit score. Opening a new line of credit can reduce your average account age, which might negatively affect your score in the short term. However, as you maintain the account and make timely payments, it can contribute positively over time.

Alternatives to a Line of Credit

While a line of credit can offer flexibility and convenience, it may not always fit everyone's financial needs. Fortunately, there are several alternatives available, each with advantages and disadvantages.

Personal Loans

Personal loans provide a lump sum repaid in fixed monthly instalments over a set period. They feature fixed interest rates, making budgeting easier, and typically do not require collateral. However, good credit is often needed for favourable rates, and interest rates can be higher than secured lines of credit.

Credit Cards

Credit cards allow borrowing up to a limit for purchases, with flexible payment options. They offer easy access to credit and often come with rewards programs. However, high interest rates can lead to debt if balances aren’t paid off promptly, and overspending is a risk.

Home Equity Line of Credit (HELOC)

A HELOC lets homeowners borrow against their property equity. It usually has lower interest rates and potential tax-deductible interest, making it an attractive option. However, it requires sufficient equity, and you risk losing your home if you don't make payments.

Payday Loans

Payday loans are short-term, high-interest loans due on the next payday, providing quick cash without credit checks. While they are easy to obtain, they carry extremely high interest and fees, leading to potential debt cycles, and are unsuitable for long-term financial solutions.

Peer-to-Peer Lending (P2P)

P2P lending connects borrowers with individual investors, often at competitive rates. This option can offer lower interest compared to traditional lenders and flexible terms. However, good credit is typically needed for the best rates, and platforms may charge fees.

Savings or Emergency Fund

Using savings or an emergency fund is a cost-effective alternative to borrowing, allowing access to funds without interest or repayment obligations. However, this option is limited to available savings and can impact long-term financial goals.

Secure a KOHO Line of Credit Today

A KOHO line of credit offers a flexible and convenient way to access funds while helping you build your credit profile. In addition to the line of credit, KOHO provides a range of powerful financial tools to support your financial journey.

With KOHO’s virtual credit card, you can build credit responsibly and securely, while the High-Interest Savings Account (HISA) helps you save for your goals faster. Plus, KOHO allows you to monitor your credit score for free, keeping you informed of your progress.

For unexpected expenses, KOHO also offers overdraft protection, ensuring you're always covered. By combining these resources, KOHO empowers you to take control of your finances, save more, and build credit—all in one intuitive platform.