Line of Credit (LOC) Types and How They Work

Line of Credit (LOC) Types and How They Work

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A line of credit is a credit facility extended by a bank or other financial institution to a government, business or individual customer that enables the customer to draw on the facility when the customer needs funds. A line of credit takes several forms, such as an overdraft limit, demand loan, special purpose, export packing credit, term loan, discounting, purchase of commercial bills, traditional revolving credit card account, etc. It is effectively a source of funds that can readily be tapped at the borrower's discretion. Interest is paid only on money actually withdrawn. Lines of credit can be secured by collateral, or may be unsecured. Lines of credit are often extended by banks, financial institutions and other licensed consumer lenders to creditworthy customers (though certain special-purpose lines of credit may not have creditworthiness requirements) to address fluctuating cash flow needs of the customer. The maximum amount of funds a customer is allowed to draw from a line of credit is typically called the credit limit or overdraft limit. The term credit limit is commonly used for credit cards whereas the term overdraft limit is more commonly used for bank accounts.

Types of Line of Credit

A line of credit comes in various forms, each of which has their own distinctions, and they can be used for individuals or businesses. All lines of credit provide the borrower with a set amount of money to use for expenses, typically with the ability to make withdrawals throughout a given period of time (draw period).

In this way, most lines of credit are more flexible than other similar products that provide financing.

Some of the general benefits are:

  • Flexibility. This is one of its main benefits. You can request a particular amount up to your limit, but you don’t have to draw the entire amount. You can tailor your use of the line of credit to your specific needs, and you’ll only need to pay interest on the amount you draw, not on the total amount you have available to you.
  • Financial safety net. If you’re faced with an unexpected expense that you can’t cover with your savings, being able to draw on your line of credit can be a great way of handling this expense until your next paycheck.
  • Flexible repayment. As long as you’re meeting your minimum payments, you can adjust how much you repay based on your budget. For example, you can pay off the entirety of your outstanding balance right away, or keep up with the minimum payments until you can pay the rest off. However, it’s always good to pay off as much as you can as soon as possible to avoid accruing more interest.

Still, it’s important to understand the differences between each type of line of credit before settling on the right one for you.

Different types of lines of credit:

  • Open-end line of credit or Revolving line of credit
  • Closed-end line of credit
  • Secured line of credit
  • Unsecured line of credit
  • Personal line of credit
  • Business line of credit
  • Cash Credit (CC)
  • Home equity line of credit (HELOC)

Let’s take a deeper dive into the different types of lines of credit.

Open-End Line of Credit or Revolving Line of Credit

Open-end credit, also known as a line of credit, allows the borrower to make repeated withdrawals throughout the draw period and payments throughout the life of the loan.

Good examples of open-end credit products are credit cards, as well as both personal lines of credit and HELOCs. For these products, once the amount drawn against the line of credit is paid back, the money becomes available to borrow from again - during the same draw period.

In this way, open-end credit is a flexible way to fund financial projects or needs that cost a significant amount of money over a longer time frame. Although it may be convenient to have a continuous line of credit, there may be additional fees associated with keeping the product open. These are often charged either annually, or broken up into monthly installments.

Closed-End Line of Credit

In contrast to open-end credit, a closed-end credit product, also known as an installment loan, provides a borrower with a specific lump sum that they would likely use to pay for a certain product or service upfront. In this way, closed-end credit is less flexible than open-end credit, since it serves a specific purpose and the money must be disbursed in one lump sum, and once repaid cannot be drawn again.

Closed-end credit products allow for money to be lent for a fixed amount of time. Typically, once a closed-end credit is originated borrowers need to make regular, scheduled payments, on both principal and interest, starting immediately thereafter.

Secured line of Credit

Secured credit is a type of loan wherein the borrower provides a security interest in something of value otherwise known as collateral in order to obtain a loan. An example of a secured line of credit is a HELOC, where the customer must pledge their home as collateral for the loan itself. Although the borrowing amount of a HELOC is dependent on how much equity the borrower actually has in their home, traditionally speaking, a secured line of credit is less of a risk for the lender, which often translates into potentially higher borrowing amounts, as well as lower interest rates.

Unsecured line of Credit

As opposed to secured credit, unsecured credit is more of a risk to the lender, since the borrower doesn't have to put up any collateral to gain the loan. A personal line of credit is a good example of an unsecured line of credit, as well as a traditional credit card. Because of the added risk to the lender, most lenders make underwriting decisions based on independent financial factors like credit score, credit history and income and may have more stringent requirements for these factors.

Business line of Credit

Businesses use these to borrow on an as-needed basis instead of taking out a fixed loan. The financial institution extending the LOC evaluates the market value, profitability, and risk taken on by the business and extends a line of credit based on that evaluation. The LOC may be unsecured or secured, depending on the size of the line of credit requested and the evaluation results. As with almost all LOCs, the interest rate is variable.

Some of the benefits to business owners include:

  • Speed - You wont need to wait for approval from the lender every time you need to make a purchase.
  • Flexibility - You can use it for nearly anything, like services, equipment and inventory. As long as it’s a business expense.

Cash Credit (CC)

A Cash Credit (CC) is a short term source of financing for a company. In other words, a cash credit is just a short-term loan extended to you by the lender or bank. It enables a company to withdraw money from the account without keeping a credit balance. The account is obviously limited to only borrowing or using up to the borrowing limit. Interest is also charged on the amount borrowed and not the borrowing limit

Home equity line of credit (HELOC)

A HELOC works similarly to a personal line of credit offering access to a set amount of cash during a set draw period as a home equity loan with one big distinction: collateral. To be eligible for a HELOC, a borrower would need to offer their home as collateral to secure the loan. In general, the amount of money available to the borrower will be based on the equity they have in their home, not the overall value of the home itself.

Like a personal line of credit, interest and monthly minimum payments for a HELOC only begin from the point where the borrower makes their first withdrawal. Maximum loan amounts should be considered when deciding between a HELOC and personal line of credit, since a HELOC loan amount is dependent on the borrower’s home equity. Interest rates for HELOCs also tend to be variable, which means that they can fluctuate throughout the life of the loan.

Limitations of Lines of Credit

The main advantage of a line of credit is the ability to borrow only the amount needed and avoid paying interest on a large loan. That said, borrowers need to be aware of potential problems when taking out a line of credit.

  • Unsecured LOCs have higher interest rates and credit requirements than those secured by collateral.
  • Interest rates (APRs) for lines of credit are almost always variable and vary widely from one lender to another.
  • Lines of credit do not provide the same regulatory protection as credit cards. Penalties for late-payments and going over the LOC limit can be severe.
  • An open line of credit can invite overspending, leading to an inability to make payments
  • Misuse of a line of credit can hurt a borrower’s credit score. Depending on the severity, the services of a top credit repair company might be worth considering.
How does a LOC work

How Does a LOC Work?

When you open a business line of credit, the business receives access to a stated amount of funds to use as needed. A monthly statement reflecting the amount of credit used will also include any interest charges (unlike a term loan, you only pay interest for the funds you use as you use them).

As mentioned above, your payment, and the interest, is based upon the funds you use. Once repaid, the credit limit is available to be accessed again as needed. The periodic payment schedule to repay a line of credit will vary depending upon the lender. Either a weekly, or monthly, periodic payment schedule is common.

In addition to the interest charges, an annual fee for a LOC is not uncommon. If your business frequently accesses the LOC, transaction fees may also apply.

Small LOCs (under $100,000) can operate like a credit card account, with advances made by using a credit card tied to the line of credit or by writing checks issued for the account. Some lenders also offer the option of depositing funds directly into the business bank account via an ACH deposit.

Applying for a line of credit

Applying for a Line of Credit

Like a term loan, most lenders will want to see financial records and documents that demonstrate a track record and demonstrate creditworthiness. Traditional lenders like banks and credit unions will require some additional documentation online lenders might not require, so it’s a good idea to find out before your first meeting with the lender what will be required. Some of the basic information you’ll need to apply could include:

  • Business License
  • Tax Returns
  • 2-3 months of bank statements
  • A business bank account
  • Standard financial documents like P&L, AR, AP, Cash Flow, etc.

You should be prepared to discuss the specifics of the business’ financial position with the lender, so any documents you may be unfamiliar with you should consult with a trusted advisor like your accountant or CPA to make sure you understand exactly what the documents suggest about the financial health of your business.

As a general rule, lenders will rarely offer a LOC to:

  • Idea stage companies or startups
  • Cover losses on past operations
  • Meet immediate expenses that won’t necessarily lead to profits

To demonstrate the business is qualified for a LOC, be prepared to show:

  • The business is profitable of generating additional revenues
  • Management understands the financial aspects of running a business
  • The business has a plan for the LOC to cover specific expenses at specific times and can demonstrate its ability to make the periodic payments

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