How Does a Line of Credit Work?
When it comes to borrowing money, you have a few options like loans and credit cards. With a loan, you receive a lump sum all at once. You then have to repay that amount, plus interest over time. You also have the option of taking out a line of credit from a bank or credit union. A line of credit is more similar to a credit card than to a loan. Letâs take a look a how a line of credit works exactly.
How Lines of Credit Work
A line of credit works like a credit card. You receive a set credit limit and your borrow money as you need. You can get a line of credit in a wide range of amounts, whether you need $1,000 or $100,000 or more. This is different from a loan, where you receive a lump sum all at once and pay it back over time. With a line of credit, you get to spread out your usage over days, months or even years. You only have to repay what youâve actively borrowed.
For example, say you need some extra money to make some home repairs. A loan would give you $10,000 upfront (if you qualify). You almost always have to start repaying that immediately. On the other hand, you can get a line of credit for $10,000 if you think youâll need that much. You can borrow whenever you need, say for a new roof one month and then a new kitchen the next. You donât even have to borrow the entire $10,000 if you need. This can help you borrow in smaller amounts which makes it much easier to pay back.
Just like credit cards, lines of credit also carry interest rates. Your credit report will determine the rate and the amount of the credit line. This rate determines how much your debt grows over time. However, the rate only applies once youâve actually borrowed and spent the money. Simply having a line of credit wonât accrue interest if you havenât spent any of it.
To access your line of credit, you can write a special check, on the institutionâs website, over the phone or in person at an institutionâs branch. This is during your âdraw period.â Youâll then pay back the money you borrowed, plus interest, during the ârepayment period.â
How to Get a Line of Credit
Just like with any credit application, youâll need to provide the lender with your personal and financial information. This includes your Social Security number, date of birth, home address, employment information, income and more. Often, itâs not enough to list the information. Youâll need to provide proof this information like pay stubs.
Lenders will also look at your credit score and credit report. They want to ensure youâre safe enough to lend to. If you have a history of making late payments or going into debt, you probably wonât qualify for a line of credit. This is especially true since lenders never know when you will actually borrow from the line of credit.
Managing Your Line of Credit
The beauty of a line of credit is that you have it there when you need it. But if you donât borrow from it, you donât have to pay a penny of interest. It can be used for home or car repairs, a wedding, college expenses and more.
As with any other type of credit, you should only borrow what you absolutely need. Itâs equally as important to pay it back as agreed. Review your bill each month and, if you can, make more than just the minimum payment. If any extra money shows up in your budget, like a raise or a bonus, put that money toward the loan. To stay on top of your payments and avoid accruing too much interest, you might want to automate your payments directly from another bank account.
Should I Get a Line of Credit?
Lines of credit are good for upcoming big purchases where the total cost isnât entirely known. Home repairs are a good example since unexpected costs do tend to spring up. You may also open a line of credit associated with your checking account if you anticipate running into overdraft fees and costs.
Youâll also want to review the fees and rates that may come with a line of credit. Fees can often includes late fees, fees for accessing your account and application fees. There may also be closing costs when you close the deal. Plus, interest rates tend to be higher for lines of credit. Theyâll go even higher if your credit isnât up to par. This will vary from institution to institution so be sure to check the paperwork or ask a representative.
Finally, itâs important to only ever borrow money when you can afford to pay it back. This means not only what you borrow, but any fees and interest you may accrue. Excessive borrowing can get you into serious trouble and debt.
Lines of credit can really come in handy when you have a big purchase in the future, but you donât know the exact cost. They allow for much more flexibility in borrowing and repaying the amounts. Plus, if youâre responsible about it, youâll end up borrowing and repaying much less than you would with a regular loan. Just always remain aware about any fees, rates and due dates so you can stay on top of your finances and debts.
Tips for Staying out of Debt
- The key to staying out of debt is simply to spend and borrow what you can afford. That way, it will be easier to pay back on time and in full so you donât incur any late fees or accrue any interest.
- If you feel yourself about to fall under a pile of credit card debt, you have the option of transferring that credit card balance to a balance transfer credit card. That will give you some time to pay back that amount at no interest. Youâll have to do so quickly, though, before the promotional period ends.
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