A line of credit is an arrangement made between a bank and a borrower. The bank offers a maximum loan amount to the borrower, which can be drawn upon at any given time. The borrower which can be an individual, business or government entity has the advantage of taking out as much as they want up to the maximum amount.
Lines of credit have a couple of important advantages.
Take for example an individual who owns a business and therefore has irregular income from month to month. The business owner applies at the bank for a personal line of credit worth $10,000 just in case he runs low on cash for a period of time. After checking his credit history, the bank agrees. If the business owner only draws $1,000 from his credit line, he’s only charged interest on that withdrawal amount. He sleeps well at night knowing that $9,000 of credit is available in an emergency.
On the contrary, if you took out a traditional loan on the same amount, you will be charged interest on the entire loan amount for $10,000 whether you use the funds or not. Some personal lines of credit are unsecured, so they don’t require a collateral, however for bigger lines of credit, residential security may need to be supplied.
Your credit card is an example of an unsecured line of credit. The popular home equity line of credit is an example of a secured line of credit where the bank places a lien on your property. The lender takes on less risk because of the lien and therefore offers a slightly lower rate. One pitfall of a credit line is that borrowers may be tempted to draw more than they actually need since the funds are readily available.
Should you get a line of credit?
A line of credit can be beneficial if you have built up a reasonable amount of equity in your home, as you can easily access it to purchase other assets or items. If you’re looking to fund a new car, you can draw down on your home equity. The advantage of borrowing for a car at home loan rates is a lower interest rate as interest rates on personal or car loans can be significantly higher than home loan interest rates.
There are also investors who use a line of credit to invest in the share market. To reduce the balance and increase the equity they have in their home, they put the money into the line of credit when they sell shares. In that way, they also draw down on equity when they want to purchase shares.
You may increase your net wealth if you use the money for investments such as property or shares. Just like an overdraft account, a line of credit lets you access additional funds by drawing on the equity value of your home. You may not plan to sell just yet, but once the value of your home has appreciated and you’re in need of extra cash to finance a home improvement or an investment property, a line of credit may be the answer.
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