Are money woes getting the best of you? Maybe the bills are piling up due to an unforeseen financial emergency that’s left you broke or your paychecks always seem to be a dollar short or a day late. If so, a personal line of credit could be just what you need to get over the hump, or at least that’s what you may have heard.
But exactly what is a personal line of credit and how does it work?
Table of Contents
- 1 What is a personal line of credit?
- 2 Benefits of a Personal Line of Credit
- 3 Drawbacks of a Personal Line of Credit
- 4 Should you apply for a personal line of credit?
- 5 Bottom Line
What is a personal line of credit?
Similar to a credit card, it is a source of funds that can be used when you’re strapped for cash. In other words, all the funds are not distributed at once.
Instead, you only withdraw what you need, usually by initiating a transfer into your account and only pay interest on the outstanding amount.
So, if you’re approved for a $1,500 line of credit and need to borrow $500 to replace your tires, you’ll transfer this amount to your checking account and withdraw the cash. At this point, your outstanding balance will be $500 plus any interest accrued if the balance is not paid in full before the due date.
Unsecured vs. Secured Lines of Credit
A personal line of credit is unsecured, so it’s not tied to any form of collateral. This means your assets will be safe even if you default on the loan (but your credit score will take a hit).
On the other hand, secured lines of credit, like Home Equity Lines of Credit (HELOCs), require that you attach some form of collateral to the loan, notes the Consumer Financial Protection Bureau. In this case, your home could be foreclosed if you fail to make timely payments.
You’ll need to have good to excellent credit to qualify for an unsecured personal line of credit. Otherwise, you may be stuck with a secured option that requires a cash deposit (typically held in a savings account or Certificate of Deposit) or a HELOC.
Benefits of a Personal Line of Credit
Competitive Interest Rates
When was the last time you checked out interest rates on credit cards? It may be tempting to swipe your plastic when you’re in a financial bind, but the interest alone could keep you in debt for several years to come.
By contrast, personal lines of credit are sometimes accompanied by substantially lower rates that will save you a bundle in interest. You may also find that the rates on personal lines are lower than what you’d find with traditional fixed-rate personal loans.
Helps Build Positive Payment History
As long as you make timely payments each month to the lender, your credit score could benefit as payment history accounts for 35 percent. But be sure to keep the balance loan or your credit utilization ratio could skyrocket, which means trouble for your credit. More on that shortly.
Another added benefit is the decrease of your utilization ratio if you refrain from drawing funds from the line. In other words, it’s beneficial to have unused credit sitting on your report.
Quick and Easy Way to Access Cash
You don’t have to wait seven days for a new credit card to arrive in the mail or resort to begging relatives and friends for money when you need it most. The personal line of credit will be available when you need it, and it only takes a few seconds to transfer the funds to your checking account and have access to the cash you need.
Ideal for Income Smoothing
If you’re self-employed, it’s not uncommon for vendors to make payments on their own timetable. No matter how many late payment stamps you embed on invoices or penalties you impose to repeat offenders, there will also be a few clients that miss payment cutoffs, which can send your finances into a frenzy.
It helps to have cash reserves on hand to smooth out your income, but if you’re in a rough patch or just getting started, a personal line of credit can provide the funds you need to pay bills and cover other expenses until the deposits and checks start rolling in.
Drawbacks of a Personal Line of Credit
Not ideal for credit newbies or those with credit challenges
Having less than perfect credit doesn’t necessarily disqualify you from getting approved. However, the unsecured personal lines of credit with the most competitive interest rates go to borrowers with good or excellent credit.
Lenders will also take your income into consideration to determine how much of a loan you can actually afford. If your income has been a bit unstable or low recently, you may not qualify for a personal line of credit.
Could Be Damaging to Your Credit Score
As mentioned earlier, you want to keep your utilization ratio to a minimum. This is the amount borrowed against the total line. So, $500 borrowed from the $1,500 line would yield a 33% credit utilization ratio. Word to the wise: lenders like to see this amount at 30 percent or lower.
But the higher your utilization ratio, the more of a hit your credit score takes as 30 percent of your FICO score is calculated by the aggregate amount owed on revolving debt.
Limited Loan Term
Unlike credit cards, personal lines of credit are only open for a set period, usually ranging between three and five years. This is commonly referred to as the draw period, and when it ends, the line will close and you’ll have to remit monthly payments over a set time frame (specified by the lender) until the balance is paid in full.
Should you apply for a personal line of credit?
It depends on your financial situation. Start by asking yourself if it’s the most inexpensive form of credit you could retrieve to find the relief you need.
If a credit card is your only other option, the answer will probably be a yes assuming the rate is substantially higher than what you’d qualify for with a personal line of credit. Otherwise, it may be best to explore other options, like balance transfer credit cards.
Another major factor to consider is how your credit utilization could be impacted. Since personal lines are reported as revolving credit, and not installment loans (which have little to no impact on your utilization ratio), taking out a line only to max it out could do temporary damage to your credit until the line is paid off.
But if you’re simply looking for a way to smooth over your income or get over a temporary rough financial patch, a personal line may not be such a bad idea. In fact, it beats incurring excessive overdraft and disconnect fees, or even worse, blemished credit due to delinquent payments on other debts.
If you decide to take out a personal line of credit, use it as a short-term solution to remedy cash flow issues. In the meantime, work on increasing your safety net so you’ll be covered when you encounter financial hurdles. Also, work on improving your credit score so you can qualify for more competitive loan products later on down the line if the need arises.