What is a Line of Credit and How Does it Work?

A personal line of credit is a kind of loan that comes with a flexible repayment schedule, and can allow you to draw on cash when you need it, but as with any loan products, there are important things to keep in mind before applying for one.

If you wish to pay for renovations on your home, or have access to cash for an investment, or even if you just want to know you have the potential to draw out funds in the case of an emergency, a personal line of credit may be an option. So what are they exactly, and how do they work? In this article, we’ll answer the questions:

What is a personal line of credit?

A line of credit loan is a type of loan that is flexible and allows you to withdraw funds up to a set credit limit, and only pay interest on the funds that you have withdrawn. A line of credit loan is similar in some respects to a credit card, in that it can be used to draw funds out when and as needed, and then repay them. Line of credit loans will typically have higher interest rates than credit cards and other types of personal loans.

There are also lines of credit available for home loans where you use your property as security against the loan.

How is a line of credit different from a standard personal loan?

A key difference between a line of credit loan and a standard personal loan is that a line of credit is more flexible. A standard personal loan will have a fixed term, at which point the principal of the loan and any interest are to be repaid. A line of credit is different, in that the borrower will have access to funds up to a set limit, and can draw on them and repay them at their own discretion, often with a flexible repayment schedule.

What can a personal line of credit be used for?

A line of credit can be used for any purpose. Some people might use one to pay for renovations on a home or to put down a deposit on an investment property, while some might use the funds to pay for life expenses such as medical bills or a car.

Some might even use it to pay for an expense such as a wedding or holiday, but before taking on debt for a purpose such as this, it is worth considering whether you are making a wise decision for your financial future by doing so.

What credit score do you need for a line of credit?

There is no strict requirement to have a certain credit score in order to be approved for a line of credit loan, although generally speaking, the higher your credit score, the more favourably lenders will consider your application. Your credit report generally shows details of all aspects of your credit history, from details of regular repayments you have made through to things such as loans and bankruptcies.

If your credit score is not as high as you would like it to be, Canstar has a series of tips for ways to improve it. A higher credit score can potentially mean that a lender might charge you less interest, or give you access to a larger amount of credit on a line of credit loan.

How hard is it to get approved for a line of credit?

Generally speaking, the lending criteria for a line of credit will be the same as applying for any other loan. You will need to supply your lender with proof of your identity, proof of a regular income (in the form of PAGY payslips), proof of savings (in the form of bank statements), and a list of your assets and liabilities. A lender will consider these things, and also take into account your credit score when deciding if and how much to approve you for.

What is the easiest line of credit to get?

Your chances of approval may also depend on whether the line of credit you are seeking is secured or unsecured. In general terms, a secured line of credit may be easier to get than an unsecured one, given the fact that lenders may consider an unsecured line of credit to be riskier.

Secured line of credit

A secured line of credit means that something will need to be used as collateral for the loan, potentially an asset you own such as a house or a car. These types of loans typically have lower interest rates attached than unsecured loans; however, the lender will have the right to sell the asset in order to recoup the balance of the loan if you fall behind on your payments.

Unsecured line of credit

Unsecured lines of credit do not require an asset to be used as security, and for this reason, lenders typically consider them riskier. It may be the case that you require a high credit score in order to take out an unsecured line of credit. It is worth keeping in mind that the interest rate attached may also be higher, and the credit limit lower.

What are the pros of a personal line of credit?

There can be convenient aspects to a line of credit, including ease of access to funds, the flexibility of repayments and the possibility of a financial safety net:

Only one application required

When you take out a personal line of credit, you will be able to keep drawing funds up to your approved limit, as well as make repayments. This means you will have the convenience of not needing to apply for a loan each time you need to borrow money, but rather, you will have one loan that will allow you to draw and repay as required. You may still be charged a monthly fee, even if you have not drawn on your line of credit.

You’re only charged interest on what you use

While the interest rates on lines of credit are typically higher than other types of loans, you will only be charged interest on the amount that you have actually drawn. Given the flexibility of lines of credit loans, however, it can be difficult to predict the amount of interest you will be charged, and the interest rate attached will typically be higher than for a standard personal loan.

A financial safety net

If you feel you are able to manage your money without being tempted to overspend on purchases that you don’t really need, then a line of credit can be a good financial safety net, and can give you access to funds if you require them in the event of a life emergency. If you feel this might benefit you, though, it may be worthwhile to seek out a lender who will not charge you a monthly maintenance fee when your line of credit is unused.

What are the cons of a personal line of credit?

There are a number of possible downsides to a line of credit, including the potential for high fees and charges and strict penalty clauses, as well as the temptation to overspend:

Higher fees and charges

The flexibility of a line of credit comes at a cost. Typically, there will be higher interest rates attached to a line of credit than there will be for a standard loan. In addition to this, a line of credit will typically have monthly fees – some lenders may charge monthly fees irrespective of whether or not the line of credit is used, and some may charge a monthly ‘maintenance’ fee if it is not.

Penalties

Lines of credit come with flexible repayment terms, but you may like to read the terms and conditions carefully to better understand exactly how much you will need to repay and the terms and conditions of the loan. Failure to abide by the loan terms could see you incurring penalties from your lender, and this could cost you significantly more than you planned for financially.

Temptation to spend

If you wish to take out a line of credit loan, it may be beneficial to first consider how well you manage money. The ease of access to funds, coupled with the flexibility of repayments, could lead to a temptation to overspend, and the accompanying high interest rates could mean that if you do not manage your money carefully, you could find yourself in quite a lot of debt.

If you are considering taking out a loan but are unsure if a line of credit is appropriate for your needs and situation, you can compare personal loans with Canstar to find a loan product with terms and features that may suit you. You may also like to consider seeking independent financial advice to support your personal decision making.

Compare Personal Loans with Canstar

The table below displays some of our referral partners’ unsecured personal loan products for a three-year loan of $20,000 in NSW. The products are sorted by Star Rating (highest to lowest) followed by comparison rate (lowest to highest). Use Canstar’s Personal Loans comparison selector to view a wider range of products on Canstar’s database. Canstar may earn a fee for referrals. Read the Comparison Rate Warning.

NEXT
What is a personal loan?

This content was reviewed by Sub Editor Jacqueline Belesky and Finance and Lifestyle Editor Shay Waraker as part of our fact-checking process.

ALASDAIR DUNCAN

Senior Finance Journalist