Taking out a personal loan or personal line of credit (PLOC) was once a last resort for individuals facing financial hardships. Today, the use of personal loans and lines of credit is rapidly increasing, as 19.4 million Americans possessed a personal loan just in 2020.
If you’re looking for a way to pay for a costly emergency repair, take care of an unexpected expense, or temporarily manage your cash flow, a personal line of credit could be the right tool for you.
What is a personal line of credit?
A personal line of credit is a form of revolving credit, meaning it’s reusable. It’s most useful for long-term projects or for borrowers with an inconsistent income stream. This type of credit differs from an installment loan, where you repay the amount in full with interest over a fixed term. Personal lines of credit are generally offered by banks, credit unions, and online lenders.
Personal lines of credit may also be secured or unsecured but are typically an unsecured type of loan. An unsecured line of credit doesn’t require any collateral; however, you can often get a better interest rate — along with a bigger loan amount — with a secured type, since you’re using some form of collateral. A personal line of credit can be a feasible option to help manage your finances, especially if you have an irregular income or are dealing with an unexpected expense.
How does a personal line of credit work?
A personal line of credit is where a lender pre-approves you to borrow a specific amount of money. You can then use the funds over time as you need them, and you pay interest only on the amount you use, rather than the full amount that’s available. The lender will approve you for a set amount of money from which you can borrow — up to a limit — for a given period of time, which is known as your draw period.
Draw periods can last a few years, and during this time, you often have the option to only make the minimum payment as you borrow. Here are a few other things to keep in mind when it comes to a personal line of credit:
- Repayment period: After a set amount of time, the line of credit goes into repayment, and you can no longer withdraw money from your account.
- Accruing interest: Interest charges begin to accrue when you start to use the borrowed money, and you usually have to make the minimum payments to continue having access to your line of credit.
- Types of interest rates: Personal lines of credit tend to have a variable annual percentage rate (APR), with a starting rate based on your creditworthiness. Some lenders do offer personal lines of credit with fixed rates, where you may be able to switch to a variable interest rate at a later date.
Variable interest rates can make it more difficult to predict your monthly payments and overall financing cost. However, the bank or lender is required to give you notice if your rate changes. Personal lines of credit with a fixed interest rate come with a set payment and repayment schedule.
A personal line of credit has several advantages when compared to other sources of borrowed money, but it’s not always the right choice for everyone. When considering whether a personal line of credit is the right move for you, it helps to consider some of the pros and cons.
- Fast access to funds: A personal line of credit gives you quick access to funds that you can borrow during your draw period. You can access this line of credit online or at a physical location, depending on your lender.
- No collateral required: Other loan options require a personal asset as collateral, whereas a personal line of credit typically doesn’t require any.
- No interest on unused funds: If you borrow up to your limit, you will pay interest on the full amount of your personal line of credit. But if you only borrow a portion of your personal line of credit, you only have to pay interest on that amount.
- Revolving funds: If you follow the terms set by the lender and you make a payment toward the personal line of credit, those funds are then available to borrow again.
- Can use it for different expenses: The money borrowed from a personal line of credit can be used to pay off urgent debts, a home repair, or any other unexpected expenses, giving you some flexibility.
- Higher interest rates: Unlike a mortgage, car loan, or other secured loans, a personal line of credit is a higher risk for the lender, which means that you may have a higher interest rate.
- Annual or monthly fees: Your personal line of credit may have a monthly maintenance fee or other fees, which you will have to pay in addition to any interest.
- Interest isn’t tax-deductible: The interest you do pay on a personal line of credit isn’t tax-deductible, which adds an extra cost when borrowing the money.
- Chance of overborrowing: Even though you can borrow up to your limit during the draw period, you must repay what you’ve used plus any interest that has accrued. So, if you don’t have a repayment plan in place, you can risk overborrowing.
How to qualify for a personal line of credit
You’ll generally need a FICO® Score in a good to excellent credit range to qualify for a personal line of credit. Many institutions offering personal lines of credit might also require you to have a checking account already with them or require you to apply through a brick-and-mortar bank, which can limit your options. Some significant qualifications when applying for a line of credit include:
- Payment history: A strong history of on-time payments shows that you’re a responsible borrower.
- Creditworthiness: Your credit score is calculated by the 3 credit bureaus and reflects your financial condition and ability to pay back your debts.
- Financial position: Your position financially can include your debt-to-income ratio, assets, and savings, which all reflect your ability to pay back money that’s borrowed.
How to apply for a personal line of credit
The process of applying for a personal line of credit is similar to applying for a new credit card or personal loan. Depending on the lender, you might be able to apply online, at a branch, or by phone.
If you’re thinking of applying for a personal line of credit, here are the steps to take:
- Look over your credit: Personal line of credit eligibility is based on creditworthiness, so it’s good to review your credit report before you apply for a loan.
- Find out the amount you need: Sit down and figure out how much money you need to apply for before comparing lenders.
- Compare lenders: Shop around and compare lenders to find a personal line of credit that fits your needs. Many lenders let you check your eligibility and rates with a soft credit inquiry, which won’t affect your credit score.
- Gather your information and documentation: You’ll definitely need your basic personal information, and some lenders require documents showing your income and employer information as well.
- Fill out the application: Once you’ve followed the steps above, you’ll then fill out and submit an application. Keep in mind when submitting an application, the lender will ask you to authorize a hard credit inquiry, which can take up to 5 points off of your credit score temporarily.
Personal lines of credit vs. other lending options
Deciding between a personal line of credit versus a personal loan or credit card will depend on your individual circumstances and financial goals. If you don’t know how much you need to borrow, a personal line of credit can be a more flexible option compared to other types of loans.
Personal line of credit vs. personal loan
A personal line of credit and personal loan ultimately work the same way — a lender lets you borrow funds based on certain terms, and you can use those funds as you need them. The difference between a personal loan and a personal line of credit is essentially the terms that come along with each, such as the repayment period and interest rate.
A personal loan can be a better choice than a line of credit if you have a fixed expense, such as a new roof, since you know exactly how much you’ll need. However, if you want more routine access to a credit line for an ongoing expense, a personal line of credit might be a better fit.
Personal line of credit vs. credit card
Personal lines of credit are similar to regular credit cards as they both have a credit limit, a monthly bill, a minimum payment due, and require interest paid based on your current balance. However, a main difference is that credit cards are meant for more regular use. You can use your credit card for everyday expenses, such as food, gas, or to pay bills. But you wouldn’t want to use a personal line of credit for those types of purchases, if possible, since the higher interest rates can end up costing you more in the end.
Although it’s good practice to keep your credit utilization below 30%, using credit cards for a huge or sudden expense isn’t always ideal, so that’s where a personal line of credit can help cover the cost. Another difference between a personal line of credit and a credit card is how you access your available credit. A line of credit may require special authorization, whereas you can usually use your credit card whenever you want, as long as you haven’t reached your limit.
What’s the difference between secured and unsecured personal lines of credit?
Personal lines of credit are most commonly unsecured. This means the lender only uses your personal information, such as your credit score and income, to determine your eligibility. A secured personal line of credit is guaranteed by collateral, which can help you qualify for a lower rate. Unsecured personal lines of credit will typically come with higher interest rates since it’s riskier for lenders to let you borrow that money without collateral.
Are there personal lines of credit for bad credit?
If you’re dealing with bad credit, it can be difficult to get approved for a personal line of credit, and if you do, you might have to deal with an extremely high interest rate. A personal line of credit may not be the best option, especially when your credit isn’t in the best shape. It may be worth considering other types of credit lines or loans, such as a personal loan or a payday loan.
What are common personal line of credit interest rates?
According to the Federal Reserve’s consumer credit data, the current average APR for a two-year personal loan is 9.58%. However, interest rates for a personal line of credit will ultimately be determined by your credit score and income, so it’s always best to shop around for the best rate before borrowing funds. Personal lines of credit typically have variable interest rates, which makes it difficult to figure out exactly how much you’ll pay in interest.
Personal lines of credit can be useful depending on your financial circumstances. They can be cost-effective solutions for routine payments that you can’t currently afford or to cover the amount of a bigger expense, such as a wedding or home repair. When taking out any loan, it’s important to pay attention to the terms and compare lenders before signing an agreement.
A personal line of credit offers flexible terms, but it’s a good idea to evaluate your needs and make sure that the monthly payment will fit into your budget. Before selecting a personal line of credit, consider all of your financing options, along with assessing your needs and spending habits. Then, pick the solution that best aligns with your circumstances and personal finance goals.