Line of Credit: What You Need to Know

Lines of credit are often referred to as the never pay back plan within the banking industry. The joke is that most people who take a line of credit do not intend to pay it back. Due to its convenience, higher approval limits, and lower annual interest than a credit card, it’s easy for people to overextend themselves. Having said that, a line of credit can be an effective way to borrow for the short or long-term, depending on the situation. The key to effectively using a line of credit is to understand how they work and always have a payback plan before you even borrow the money.

What is a line of credit?

A line of credit is a revolving credit product similar to a credit card. Once approved for one with a set limit, you’re not required to re-apply as long as you stay within your credit limit and make the minimum payments required each month.

What’s the main difference between a line of credit and a credit card?

The are three primary differences between the two products. First, a line of credit has a much lower annual interest rate than a credit card, especially if it’s secured. Secondly, a line of credit’s annual interest rate comprises two parts. The first part includes the bank’s prime rate, and the second is an adjustment factor. The two parts together make up your overall interest rate. For example, if the prime rate is 3.45% and your adjustment factor is 3%, then your overall annual rate is 6.45%, subject to changes in the prime rate. The last main difference is how interest is charged. A line of credit interest is charged daily with no grace period. Once you use your line of credit, interest is charged immediately, unlike a credit card that usually offers you an interest-free grace period.

What is the difference between a secured line of credit and an unsecured line of credit?

A secured line of credit usually has a security or collateral which the credit line is secured against. The most common form of a secured line of credit is a home equity line of credit, where the home is the collateral or security. Financial institutions generally offer a lower interest rate on a secured line of credit as their risk of losing money on the loan is lower, given there is a security to offset any potential losses.

An unsecured line of credit is not secured by anything, which means the issuer (such as a bank) is at a greater risk. If you should default on the line of credit, the issuer has no asset which it can collect on to cover the loss. As a result, the annual interest rate is much higher than a secured line of credit.

How is the annual interest rate determined on a line of credit?

As I mentioned, part of your annual interest rate comprises the current prime rate. The second portion is known as your adjustment factor. This rate is determined based on your overall credit history. For example, assume you applied for an unsecured line of credit, and prime is currently 3.45%, and your adjustment factor was 3%. Based on that information, your overall annual interest rate will be 6.450%, subject to changes in the prime rate.

Typically, your adjustment factor shouldn’t change, but it’s possible for your rate to be adjusted based on poor payment history.

What is the typical annual interest rate for a secure or an unsecured line?

• The typical rate for a secured line of credit is prime+.5 to 1%. Usually, with a good credit history, you should prime+.5.
• The rate can range from prime+2.5% for an unsecured line of credit.

Are there any annual fees with a line of credit?

• There is no annual fee for either a secured line of credit or an unsecured line of credit. However, a secured line of credit can have legal fees to initially set up and discharge fees to close the account down. An appraisal is also required, which you might have to pay depending on how you go about your application.

What are the payment options for a line of credit?

Both secured and unsecured lines offer flexible payment options that can be a little as interest-only payment or pay the full balance owed. Most financial institutions usually offer a range of payment options you can select from.

While the interest-only payment option might be great for affordability, it’s a terrible way to pay back the debt. In fact, if you simply back interest on your line of credit, you will never back pay back the debt. I advise picking an option that pays some interest and principal back each month.

Best practices with a line of credit

The important thing to always remember with a line of credit is to ensure you set up a plan that will enable you to pay off the entire balance and not just covering interest payments only. Interest-only payments give you the illusion that you’re paying back your debt, but in reality, you are doing nothing to pay back the debt. Remember, the interest rate on a line of credit isn’t fixed, as the prime rate is subject to change. That being the case, it’s important you ensure you can handle a 1-2% increase in the overall interest rate you’ve been approved for. Avoid at all costs using your line of credit to finance vacations or supplement your income. Doing that will surely make you know why it’s sometimes called the never-payback plan. Keep it simple; use only what you can afford to pay off.