Line of credit

Definition

A line of credit is a financial arrangement that allows an individual or a business to borrow a specific amount of money from a lender up to a predefined limit.

What is a line of credit?

Unlike a traditional business loan where you receive a lump sum amount upfront, a line of credit provides the flexibility to borrow and repay funds as needed. Interest is typically only charged on the amount borrowed, and once repaid, that portion of the credit becomes available for borrowing again. It’s a useful financial tool for managing short-term expenses or unexpected costs. Try our line of credit calculator today and find out if it is right for you.

Types of line of credits

• Personal line of credit: A flexible loan for personal use, typically unsecured and based on creditworthiness.
• Home equity line of credit (HELOC): Secured by the equity in a borrower’s home, often used for home improvements or major expenses.
• Business line of credit: Designed for business purposes, providing working capital and helping manage cash flow.
• Credit card: A revolving line of credit used for everyday purchases, with a set credit limit.

Unsecured vs. secured line of credit

An unsecured line of credit is not backed by collateral, relying solely on the borrower’s creditworthiness, and typically comes with higher interest rates due to increased lender risk. A secured line of credit, on the other hand, is backed by collateral such as a home or savings account, often resulting in lower interest rates due to reduced risk for the lender.

Both types provide flexible access to funds but differ in terms of risk, interest rates, and approval criteria.

Revolving vs. non-revolving line of credit

A revolving line of credit allows borrowers to access funds up to a set limit, repay, and borrow again as needed, offering ongoing flexibility similar to a credit card. A non-revolving line of credit provides a one-time borrowing limit that, once repaid, cannot be borrowed again, functioning more like a traditional loan.

Both types offer access to credit but differ in their borrowing and repayment structures.

How does a line of credit affect credit score?

A line of credit can affect a credit score in several ways. Opening a new line of credit may result in a hard inquiry, which can temporarily lower the credit score. Responsible use, such as making timely payments and keeping the credit utilisation ratio low, can improve the credit score over time. Conversely, missed payments or high utilisation can negatively impact the credit score. The overall effect depends on how the line of credit is managed.

Example of a line of credit

ABC Retailers is a local store that sells electronics and home appliances. The business experiences seasonal fluctuations in sales and occasionally faces challenges with cash flow.

ABC Retailers is approved for a $50,000 line of credit. This means the business has access to a revolving credit facility with a maximum limit of $50,000. The funds can be drawn upon as needed to address short-term cash flow challenges.

The line of credit provides flexibility in repayment. ABC Retailers can choose to repay the drawn amount in full or make minimum monthly payments based on the terms agreed upon with the bank.