What is a Personal Line of Credit
A personal line of credit is an unsecured revolving account with a variable interest rate allowing you to borrow money as you need it. Essentially, you can use it as a credit card to cover significant expenses at places that don’t take credit.
The Major Benefits of a Personal Line Of Credit:
First, I would like to be clear that you never want to borrow money unless absolutely necessary. I use a personal line of credit to smooth out major expenses and want to share what I learned looking for and setting up my account.
Warning: If your problem is an imbalanced budget, a personal line of credit is not the answer. Borrowing for routine living expenses is a sure-fire way to end up in the poor house.
The main benefits of a Personal Line of Credit are the convenience and flexibility it offers to help meet changing financial situations. Depending on how you use it, a personal line of credit may be cheaper than a credit card cash advance, more flexible than a personal loan. Plus, it won’t require collateral as does a home equity line of credit, but it’s not for everyone.
Basics of a Personal Line of Credit
- A competitive variable interest rate (Single digits but not 0%)
- No collateral required
- Line amounts from $3,000 to $100,000
- No cash advance or balance transfer fees (Move money back and forth quickly)
- Low annual fee of $25
- Interest rate discounts may be available if you have multiple accounts/products at the bank.
Robert was renovating his 1800’s Victorian home and had to use his savings to fix an unexpected plumbing leak that was found in a wall. Next month, tuition was due for the private schools his three kids attend. What was he to do? Robert had other assets including certificates of deposit, bonds, and stock accounts, but didn’t want to cash out those assets to get through this short-term hump in his finances.
This situation is exactly where a personal line of credit is helpful. It is a form of credit that a person can access on a regular or irregular basis to get from a bad month to a good month. High-income professionals tend to have more significant budget blips that necessitate either a healthy emergency fund or quick access to capital. In Robert’s situation, he used it to bridge him a couple of months through a temporary cash crunch when two big blips coincided.
Why Don’t I hear More About A Personal Line of Credit
Because collateral does not secure a personal line of credit, they are offered to professionals with a strong credit history. Not only do you need to have a strong credit score but also demonstrate an ability to repay the line.
The better your credit rating, the more likely you are to get a personal line of credit on good terms. There are not many individuals who would qualify. Thus this is not a heavily promoted product.
The line of Credit vs. Credit Card Cash Advance
A line of credit is used in the same way that we use credit cards to cover monthly expenses. The difference is the personal line of credit is used once or twice a year to meet major expenses as a safety net for unexpected events. While credit cards may be easier to obtain, the interest rates for carrying a balance can be much higher.
Use of personal and business lines of credit have mostly been replaced by credit cards with their vast array of reward programs and 0% interest rate offers.
Back to the Example
For most individuals, using credit cards may make sense, but let’s look at our example from above:
Robert had 3 tuitions at $12,000 each for $36,000 total. For many, it can be hard to find a credit card that has a 0% balance transfer check and a high enough credit limit without building this limit ahead of time. The balance transfer checks will usually have a 2-3% upfront fee for a finance charge of $720-$1080 for the transaction.
If you have a personal line of credit, your interest rates may vary, but at 6-8% APR, you will pay a total interest charge of $2,160-2,880 if you carried the balance for the year.
If you can pay off the balance within a month or two, then you will end up saving yourself a few hundred dollars.
For a line of credit to make sense, you will need to have the cash flow to pay down your balances quickly, or you will end of paying more than if you had used a balance transfer check from a credit card company.
Consolidating Credit Card Debt
Some people may use a personal line of credit as a consolidation loan to pay off credit card debts. It’s possible mathematically to save money doing this, but it’s highly unlikely.
If you have already maxed out all your credit cards and you’re thinking “Where can I go to get more money?” a personal line of credit is not a good idea. A person who has debt issues is unlikely to qualify for a line of credit but even if they qualify; they are going deeper into debt. This is much like taking out payday loans because there are no other options. It represents uncontrolled borrowing and is a sign of impending default.
If you’re not disciplined enough to avoid borrowing more than you can reasonably pay back, -skip the line of credit.
The Line of Credit vs. Personal Loans
If I had to describe a personal line of credit in one word, it would be FLEXIBLE. A personal line of credit allows you to borrow only the money you need and offers a variable interest rate that is lower than a fixed loan rate. Your payments are then variable depending on the outstanding balance.
In contrast, a personal loan is best suited for paying off a high-interest debt that carries a fixed interest rate and fixed monthly payment. You receive the entire loan amount up front and cannot dip into it again. The fixed term and rate allows you to know precisely when your loan will be paid off. The perfect example of this is a consolidation loan for credit card debt.
Because the payments of a personal line of credit vary depending on how much you borrow and how much you decide to pay back, you never really know when you will be debt-free. Ideally, this shouldn’t be a factor because you are paying the line down ASAP.
The Line of Credit vs. Home Equity Line of Credit
If you own your house, a home equity line of credit is another option you should consider instead of a personal line of credit. The interest rate on an HELOC will be lower because the home is used as collateral. Because of these benefits, the HELOC is commonly used by physicians and other professionals to cover variable personal expenses.
The remote but significant risk with an HELOC is that whenever you use collateral, you are putting that collateral at risk. If you can’t repay the HELOC, you can lose your house. A person can lose their home due to excess personal spending if they put this expenditure on the HELOC. A personal line of credit is not secured, so it is a safer loan for the consumer.
A HELOC may not be right for you if you’re upside on your mortgage and thus have no equity. In that case, you likely won’t qualify for a HELOC. You may still qualify for a personal line of credit in this situation.
This represents an opportunity for individuals with good credit who got caught in a poor real estate market.
A lack of home equity doesn’t show up on your credit report. Just because the value of your home declined in a massive real estate bust, that’s not predictive of whether they can pay a loan back. If you have a strong credit history, that’s heavily weighted when you’re seeking a personal line of credit.
How to Qualify for a Personal or Business Line of Credit
Like all forms of credit. It is always better to apply for credit BEFORE you need it. If you have maxed out your other lending options or do not have much cash flow, it will be harder to get approval.
The key point with all forms of debt is that you need to apply for it and have it available BEFORE you need it.
Even if you don’t have any need for extra borrowing capacity, disciplined early career physicians who don’t have a large nest egg to tap in emergencies should consider opening a personal line of credit as an insurance policy against large unexpected expenses.
The lenders who offer lines of credit will typically base their decision on the following factors:
- Credit Score ( min 600+, If you don’t know yours check here ) Your credit score is a must know number for anyone who uses any form of credit today, which is 90%+ of people.
- Time in Business (obviously for businesses, more time is better, need at least six months)
- Recent Revenue ( need to see that you are actually making money as a business or have a paycheck as an individual)
- Short Term Assets ( For businesses this is accounts receivable, for personal its cash in the bank, retirement accounts.)
- Hard Assets ( For businesses this is equipment and real estate, for personal by definition they are not using hard assets as collateral but may want to know cars, homes, etc..)
A better-qualified buiness or person will qualify for a larger credit line with lower interest rate and a better repayment schedule.
A less qualified borrower may see a lower credit line extended and will likely pay a higher interest rate on that line.
Online lenders tend to be faster and less restrictive with their lending standards. This speed and availability come with the trade-off of much higher APRs.
Because of these higher APRs, This is a reason why many startups and small businesses turn to small business credit cards are an attractive option to using revolving lines of credit.
Small business credit cards can be such an effective line of credit for new small businesses that even startups can qualify if they have a good credit score and can prove the ability to pay on time.
The Downsides to a Line of Credit
There are downsides to all forms of credit. These downsides are why many people operate on a cash only basis. It avoids all credit problems. If you don’t owe anyone anything, your personal and buiness flexibilty go way up. Proper use of capital and leverage is one way to improve your financial situation.
A Business or Personal Line of Credit can be Reduced or Called in
The fact that a line of credit is “callable” is, in my opinion, the biggest downfall to a line of credit. Every lender I have seen reserves the right to reduce or cut off the borrowers access to the line of credit if their business revenue falls or their creditworthiness falls.
For a business line of credit, most lenders will require financial statements to renew and maintain the line of credit every year or so. If your business finances change to the point that you no longer qualify for the line of credit, the lender may reduce or call in the line of credit.
For personal lines of credit, the renewal cycle and required financial statements are less frequent and I have not been asked to go through a renewal cycle.
For a business, the reduction in a line of credit is doubly troublesome. It is often in these difficult times that access to credit is needed to bridge the gap through the downturn, but it is during these downturns that lenders get skittish are more likely to call in a line of credit.
Often what happens in this situation is that you will look for a different lender who will refinance the debt with a term loan. Swapping a line of credit for a fixed loan is good and bad. While it will not be a revolving line of credit, a loan can be spread out over a longer payment period and can give you a lower monthly payment to ease cash flow issuse.
You Can Negatively Impact Your Credit Score
If you have used a high percentage of the line of credit, it could adversely affect your credit score due to high utilization. On the flip side, If you have the line open and are not utilizing it, it makes your credit score look better because it lowers your utilization ratio.
While the credit requirements for a line of credit and personal loans are very similar, the two products are very different in their uses.
Lines of credit are best used as an affordable option for short-term working capital or emergency financing access. For purchases of real assets, you are better off with a loan designed specifically for that product.
Most individuals will find that they can get along just fine with credit cards and a HELOC, but for some of you all out there a line of credit may make sense.
My Personal Experience:
My experience was that I applied for a personal line of credit ahead of my renovation to have some financial flexibility if the budget went way off target. Well, the renovation went 50% over budget, and we needed every ounce of financial flexibility.
We have been carrying a fluctuating balance on the personal line of credit for the past six months which is not ideal. If it looks like we cannot get the balances paid off in the next couple of months, we will use a 0% balance transfer check to lower the rate and set an endpoint to have this debt repaid.
Do you have a Personal Line of Credit? Would you just use 0% balance transfers and do the extra work?
Warnings & Examples
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