Credit is quite a common means of funding that people employ both for personal and business purposes. Today, the market has a hoard of offerings of credit type. And you, as the financial consumer can choose what suits you the best. A line of credit (LoC) in banking is one of the simplest and easiest source of funds. It is handy especially if you are seeking flexible access and repayments.
What is a Line of Credit And How Does it Work?
A line of credit is an arrangement between a bank / financial institution and the borrower. It allows the borrower to maintain a maximum loan balance account with the lender, this is referred to as the “line of credit account.” You can access funds from this continuous revolving credit account. The lender and borrower get into an agreement which lays out the terms of borrowing. It also includes a maximum threshold limit up to which the customer can borrow. Other terms include a minimum monthly payment to be made or a specific tenure till which the revolving process works.
Opening a Line of Credit
You can opt for a business line of credit or a personal line of credit. Either way, the LoC can be secured or unsecured i.e. with or without a collateral. When opting for a business line of credit, the banking or lending institution will evaluate your company’s financial status, and accordingly allocate the revolving amount and highest withdrawal threshold.
Line of Credit vs Loan
The basics of LoC are very similar to that of a loan. Both are a credit instrument which allows access to funds based on a repayment interest rate. However, in a loan, a lump sum amount is disbursed for the perusal of the borrower, and interest is charged on the entire amount lent, whether the borrower uses that entire amount or not. As opposed to this, in Line of Credit, a revolving amount is available to the borrower, and interest is charged based on funds utilisation rather than funds allocation.
Who Should Opt For a Line of Credit?
A line of credit arrangement is commonly used by businesses to offer customers the privileges of flexibility and funds-access at the same time. This also helps businesses streamline their “working capital” requirements. It also helps them manage their current account funds so as to finance their current assets like raw materials or wages. People often wonder what can line of credit be used for in the personal context. It finds application in funding emergency needs such as a medical event, or even a major event like a wedding in the family. Some people also use the line of credit as a consolidation loan. It is used to pay off credit card debt, though this may not be a great idea.
Advantages of Credit Line
- Flexibility: Because of the revolving nature of the credit account, the credit account will technically be always available, at any time. This works well for businesses where the expenses cycle may be seasonal and not regular. The businessman can tap into the funds as and when the need arises.
- Less Costly: In a LoC arrangement, you need not pay the interest on the entire amount lent. You have to pay interest only on the amount that you actually use, in the said time frame. This reduces the cost of lending, especially in cases where the fund utilisation is not high.
Disadvantages of Credit Line
- Because of the unsecured nature of the loan that Line of Credit is, the interest rates may fluctuate as per the bank interest rates. You may end up paying much more interest than what was agreed upon at the outset. Thus, making the entire arrangement quite expensive sometimes.
It is important to remember that even with its flexibility, a Line of Credit is ultimately a credit tool. That is, you are borrowing from an external party, and are expected to return it along with interest. Hence, it’s a good idea to borrow within your means and keep a close tab on the expected repayments, lest you default on payments and end up hurting your credit score or CIBIL score.