Lines of Credit

This loan option can work well
under the right circumstances

Businesses have been using credit lines for years to meet working capital needs and/or take advantage of strategic investment opportunities.

A bank business Line of Credit is ideal if your business needs easy access to cash for short-term capital, inventory purchase, supplier payment or an emergency fund.
  • $10,000 to $500,000 line of credit
  • Annual fee is automatically waived when your average line utilization is 40% or more
  • Renewable five-year revolving term
  • You pay interest only on the amount of credit you actually use
  • You can choose a monthly payment date that suits your cash flow
  • The monthly minimum payment is accrued interest plus 1% of the outstanding balance — OR $100, whichever is greater
  • At the end of the five-year revolving term, no further advances are available and the outstanding principal balance is repaid over five years, unless renewed
  • The interest rate is based on such factors as your banking relationship, credit history and collateral

Here, then, are some of the basics about lines of credit.

  • A line of credit is a flexible loan from a financial institution that consists of a defined amount of money that you can access as needed and repay either immediately or over time.
  • Interest is charged on a line of credit as soon as money is borrowed.
  • Lines of credit are most often used to cover the gaps in irregular monthly income or finance a project whose cost cannot be predicted up front.

What Is a Line of Credit?

A line of credit is a flexible loan from a bank or financial institution. Similar to a credit card that offers you a limited amount of funds—funds that you can use when, if, and how you wish—a line of credit is a defined amount of money that you can access as needed and then repay immediately or over a prespecified period of time. As with a loan, a line of credit will charge interest as soon as money is borrowed, and borrowers must be approved by the bank, with such approval a byproduct of the borrower’s credit rating and/or relationship with the bank. Note that the interest rate is generally variable, which makes it difficult to predict what the money you borrow will actually end up costing you.

Lines of credit tend to be lower-risk revenue sources relative to credit card loans, but they do complicate a bank’s earning asset management somewhat, as the outstanding balances can’t really be controlled once the line of credit has been approved. They address the fact that banks are not terribly interested in underwriting one-time personal loans, particularly unsecured loans, for most customers. Likewise, it is not economical for a borrower to take out a loan every month or two, repay it, and then borrow again. Lines of credit answer both of these issues by making a specified amount of money available if and when the borrower needs it.

When a Line of Credit Is Useful

By and large, lines of credit are not intended to be used to fund one-time purchases such as houses or cars—which is what mortgages and auto loans are for, respectively—though lines of credit can be used to acquire items for which a bank might not normally underwrite a loan. Most commonly, individual lines of credit are intended for the same basic purpose as business lines of credit: to smooth out the vagaries of variable monthly income and expenses or to finance projects where it may be difficult to ascertain the exact funds needed in advance.

Consider a self-employed person whose monthly income is irregular or who experiences a significant, often unpredictable delay between performing the work and collecting the pay. While said person might usually rely on credit cards to deal with the cash-flow crunches, a line of credit can be a cheaper option (it typically offers lower interest rates) and offer more-flexible repayment schedules. Lines of credit can also help fund estimated quarterly tax payments, particularly when there is a discrepancy between the timing of the “accounting profit” and the actual receipt of cash.

In short, lines of credit can be useful in situations where there will be repeated cash outlays, but the amounts may not be known upfront and/or the vendors may not accept credit cards, and in situations that require large cash deposits—weddings being one good example. Likewise, lines of credit were often quite popular during the housing boom to fund home improvement or refurbishment projects. People would frequently get a mortgage to buy the dwelling and simultaneously obtain a line of credit to help fund whatever renovations or repairs were needed.

Personal lines of credit have also appeared as part of bank-offered overdraft protection plans. While not all banks are particularly eager to explain overdraft protection as a loan product (“It’s a service, not a loan!”), and not all overdraft protection plans are underpinned by personal lines of credit, many are. Here again, though, is an example of the use of a line of credit as a source of emergency funds on a quick, as-needed basis.

The Problems with Lines of Credit

Like any loan product, lines of credit are potentially both useful and dangerous. If investors do tap a line of credit, that money has to be paid back (and the terms for such paybacks are spelled out at the time when the line of credit is initially granted). Accordingly, there is a credit evaluation process, and would-be borrowers with poor credit will have a much harder time being approved.

Likewise, it’s not free money. Unsecured lines of credit—that is, lines of credit not tied to the equity in your home or some other valuable property—are certainly cheaper than loans from pawnshops or payday lenders and usually cheaper than credit cards, but they’re more expensive than traditional secured loans, such as mortgages or auto loans. In most cases the interest on a line of credit is not tax deductible.

Some banks will charge a maintenance fee (either monthly or annually) if you do not use the line of credit, and interest starts accumulating as soon as money is borrowed. Because lines of credit can be drawn on and repaid on an unscheduled basis, some borrowers may find the interest calculations for lines of credit more complicated and be surprised at what they end up paying in interest.