Line of Credit

Line of Credit

What is a Line of Credit?

Definition

A line of credit allows a customer to borrow from a bank or a financial institution in a flexible manner. What this means is that a line of credit for, say, $100,000 may be established, but the borrower may draw only the sum that is required. Interest is payable only on the borrowed amount. Consequently, the interest cost that the borrower pays can be minimized.

What does a line of credit mean?

In addition to flexibility, a line of credit has other advantages too. For example, a line of credit is usually a revolving facility. When the sum advanced by the lender is repaid, the line is available for use once again. This saves the borrower the trouble of approaching the financial institution for the second time.

A line of credit may be secured or unsecured. A common form of a secured line of credit is a home equity line of credit (HELOC). The lender provides funds against the security of your home. The line that is set up would not be for the full value of your home. The financial institution would insist of a margin of 15% or more. If the value of your home is $1 million, the line of credit could be for a sum of $850,000.

Secured lines of credit usually carry low rates of interest. Unsecured lines, which do not require any collateral to be provided, are more expensive.

Example of a line of credit

Andrew Porter purchased his home back in 1998. It is now in need of extensive repairs. Andrew decides to borrow a sum of $75,000 for this purpose. He approaches his bank and is informed that he can establish a HELOC. The rate of interest is 3.49% for the first year. Subsequently, it will be raised to 5.18%.

The “draw” period for the line is ten years. During this time, Andrew can draw any amount that he requires up to the limit of $75,000. Andrew’s repayments in the first ten years will be limited to the interest on the actual amount that is borrowed. After the draw period ends, he will be required to pay principal as well as interest.

Andrew decides to establish the HELOC as the rate of interest is relatively low and he is confident that he will be able to meet his repayment commitments.

Summary

A line of credit is a flexible loan arrangement. As money can be drawn whenever it is required, interest costs can be minimized.