A line of credit is a type of loan that financial institutions such as banks or credit unions open for clients to allow them to borrow money when they need it, up to a preset limit.
With a line of credit, you only have to pay interest on the money you borrow. The available credit is replenished as you pay back the funds. Lines of credit work pretty much the same way as credit cards, but their interest rates can be significantly lower.
How do lines of credit work?
A line of credit gives you access to money when you need it. And it can be a very flexible way of borrowing. This type of standing loan is typically available to both individuals and businesses and makes it easy to continue borrowing without having to apply for a new loan.
Unlike in the case of a loan, where you get a lump sum of money and start paying interest at once, a line of credit gives you access to a set amount of money and you get to choose how much to borrow and when.
Personal credit lines can be secured or unsecured, and some of them come with annual fees. If you have a good credit score, you can qualify for a lower annual percentage rate. The period in which you can draw money from your line of credit varies, but typically it lasts for several years, so you don’t need to apply again.
Interest starts to accrue only after you borrow money from the line of credit, not from the moment it’s approved. Because you only pay interest when you actually use the credit line, setting one up can be a good strategy for “rainy day” expenses.
Does a line of credit have an impact on my credit score?
Just like in the case of a credit card account, lines of credit are a form of revolving credit. The lender authorizes you to borrow up to a maximum credit limit. You can then make repayments in variable amounts of time. Be aware that credit lines can have a significant impact on your credit scores.
Lenders typically perform a hard search on your credit report when you apply for a line of credit. This hard inquiry alone can lower your credit score by a number of points.
If you accept the line of credit offered by the bank, it can appear on your credit report as a new account. The impact it has on your credit score depends on the way you use it.
If you only use a small percentage of the maximum amount you have available, or you don’t use it at all, having a line of credit can positively impact your credit score because it lowers your credit utilization rate. However, if you borrow a high percentage of the line, this may have a negative impact on your credit score because it increases your utilization rate.