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LINES OF CREDIT
When it comes time for people to borrow money, there
are many choices available. Borrowers can go to a bank
for a traditional fixed or variable-rate loan, turn to
pawnshops or payday lenders (though neither is a good
idea apart from the most dire of circumstances), use
credit cards, borrow from friends or family, or even
turn to the web and specialized “social lending” or
donation sites.
One of the lesser-known and lesser-used options is a line
of credit. Businesses have been using lines of credit
for years to meet working capital needs and/or take
advantage of strategic investment opportunities, but
they’ve never quite caught on as much with individuals.
Some of this may be due to the fact that banks don’t
often advertise lines of credit, and potential borrowers
don’t think to ask. Here, then, are some of the basics
about lines of credit.
What it Is
A line of credit is basically a flexible loan from a
bank or financial institution to an individual or
business. Not unlike how a credit card offers you a
limited amount of funds that you can use when, if, and
how you wish, a line of credit is a limited/specified
amount of money that an individual can access as needed
and then repay immediately or over a pre-specified
period of time. As a loan, a line of credit will charge
interest as soon as money is borrowed, and borrowers
must be approved by the bank (and such approval is a
byproduct of the borrower’s credit rating and/or
relationship with the bank).
Banks have only recently begun to market these products
to any significant extent. This may be a byproduct of an
economy that has reduced loan demand and new regulations
that have restricted fee-based sources of income. Lines
of credit tend to be lower-risk revenue sources relative
to credit card loans, but they do complicate a bank’s
earning asset management somewhat, as the outstanding
balances can’t really be controlled once the line of
credit has been approved.
When a Line of Credit is Useful
A line of credit addresses the fact that banks are not
terribly interested in underwriting one-time personal
loans, particularly unsecured loans, for most customers.
Likewise, it is not economical for a borrower to take
out a loan every month or two, repay it, and then
continue the cycle. Lines of credit answer both of these
issues by making a specified amount of money available
if and when the borrower needs it.
By and large, lines of credit are not intended to be
used to fund single one-time purchases such as houses or
cars – that is what mortgages and auto loans are for –
though lines of credit can be used to acquire items for
which a bank might not normally underwrite a loan. Most
commonly, individual lines of credit are intended for
the same basic purpose as business lines of credit – to
smooth out the vagaries of variable monthly income and
expenses, and/or to finance projects where it may be
difficult to ascertain the amount of funds needed
upfront.
Consider a self-employed person whose monthly income is
unpredictable or where there is a significant (and/or
unpredictable) delay between performing the work and
collecting the pay. While this might normally be a
situation where people would turn to a credit card, a
line of credit can be a cheaper option (lower interest
rates) and offer more flexible repayment schedules.
Lines of credit can also be useful in these situations
to help fund estimated quarterly tax payments,
particularly when there is a discrepancy between the
timing of the “accounting profit” and the actual receipt
of cash.
Lines of credit can be useful in situations where there
will be repeated cash outlays, but the amounts may not
be known upfront and/or the vendors may not accept
credit cards, and in situations that require large cash
deposits – weddings being one good example. Likewise,
lines of credit were often quite popular during the
housing boom to fund home improvement or refurbishment
projects – people would frequently get a mortgage to buy
the dwelling and simultaneously obtain a line of credit
to help fund whatever renovations or remodeling were
needed.
Personal lines of credit have also appeared as part of
bank-offered overdraft protection plans. While not all
banks are particularly eager to explain overdraft
protection as a loan product (“it’s a service, not a
loan!”) and not all overdraft protection plans are
underpinned by personal lines of credit, many are. Here
again, though, is an example of the use of a line of
credit as a source of emergency funds on a quick,
as-needed basis.
The Problems with Lines of Credit
Like any loan product, lines of credit are both
potentially useful and potentially dangerous. If
investors do tap a line of credit, that money has to be
paid back (and the terms for such paybacks are spelled
out at the time when the line of credit is initially
granted). Accordingly, there is a credit evaluation
process and would-be borrowers with poor credit will
have a much harder time being approved for a line of
credit.
Likewise, it’s not free money. Unsecured lines of credit
– that is lines of credit not tied to the equity in your
home or some other valuable property – are certainly
cheaper than loans from pawnshops or payday lenders, and
usually cheaper than credit cards, but they’re more
expensive than traditional secured loans such as
mortgages or auto loans. In most cases, the interest on
a line of credit is not tax deductible.
Some, but not all, banks will charge a maintenance fee
(either monthly or annually) if you do not use the line
of credit, and interest is charged as soon as money is
borrowed. Because lines of credit can be drawn on and
repaid on an unscheduled basis, some borrowers may find
the interest calculations for lines of credit more
complicated and may surprised at what they end up paying
in interest after they borrow from a line of credit.
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