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How does a line of credit work?

Have easy access to additional funds whenever you need them with a line of credit.

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A line of credit can provide you with a convenient way to draw on funds as and when you need to. You can use the funds to consolidate debt, make multiple purchases or as a safety net in case of an emergency.

Find out if a line of credit is right for you in our guide.

How does a line of credit work?

A personal line of credit works much like a credit card, in it gives you a specified credit limit to use how you like. The main difference is the limit is usually higher, while the interest rate is lower in comparison to a credit card. You don’t need to submit a credit application every time you need to make a withdrawal.

Once you are approved, you can withdraw funds when you need up to a predetermined limit. Interest is only charged on the amount you have withdrawn, not on the entire credit limit.

You can get a line of credit that is linked to your debit card for more flexibility.

What is the difference between a line of credit and a personal loan?

There are four main differences between a line of credit and a personal loan.

  • Loan term. Personal loans have a fixed term, anywhere between one and seven years, and you pay them back in full by the end of the term. However, lines of credit don’t come with a “term”, and the funds you borrow become available again after you repay the money – plus interest.
  • Repayments. Both options involve monthly repayments. However, a personal loan has a fixed monthly payment while a line of credit depends on the previous balance, the amount you draw, accruing interest and other factors.
  • Time of disbursement. With personal loans, your lender will disburse the funds upfront as soon as you agree to the loan contract and sign it. With a line of credit, you can withdraw up to your approved limit on an ongoing basis as long as you meet the minimum monthly repayments.
  • Fees. Personal loans typically charge monthly service and application fees, while a line of credit usually comes with annual service fees. However, lenders for both personal loans and lines of credit may charge a variety of other hidden costs. Make sure you’re always aware of any fees for the options you’re considering.

How to compare your line of credit options

If you are considering a line of credit, it is important to compare your options so you get the right loan for you. Here are some features to keep in mind when looking at the accounts available:

  • The interest rate. Not only will you want to compare different interest rates, you will also want to learn how they are applied. Check that interest is applied only to the funds you withdraw, not on your total balance. Also, keep in mind that in some cases you may have the option of securing the loan against an asset, which may result in a lower interest rate.
  • The fees. Compare fees carefully as they are not always set out as clearly as the interest rate. While a line of credit may advertise no annual fee, there could be monthly fees or an establishment fee. Make a running list of fees for each option you are considering and factor that into your loan amount. You can also use a personal loan calculator to do this.
  • The terms of the loan. There are two different term types to consider. One is known as a term plan, where you have a certain timeframe, usually between one and five years, to pay off the principal of the line of credit. The other line of credit personal loan allows you to keep the loan open as long as you continue to make regular monthly repayments. This is also known as revolving credit and may be ideal if you want a funding source available as a safety net for unexpected expenses.
  • How accessible are your funds? Another thing to consider with this type of loan is how you access your funds. Again, read these terms carefully. A bank may offer a card that can be used at ATMs, but there may be charges applied for this convenience. You need to weigh up the methods of accessing the funds, along with any fees associated with them.

What are the benefits?

  • You’re only charged for what you use. In most cases, you are only charged interest on the funds you have borrowed, as opposed to the total loan amount.
  • You have easy access to your funds. If your account is linked to a card, you are able to draw the funds through ATMs and online banking. You can withdraw funds from your line of credit whenever you like, as long as it doesn’t exceed your maximum credit/daily limit.
  • No fixed repayments. As long as you make a minimum monthly payment (a percentage of the withdrawn funds), there’s no fixed repayment amount.
  • Option to increase the maximum credit limit. Your lender may provide the opportunity to raise the maximum credit limit in line with your specific needs.

    What are the risks?

    • Overspending. For individuals with little financial control, the thought of a seemingly unlimited amount of funds may cause them to make unnecessary purchases.
    • Penalties. While the repayments for a line of credit personal loan are generally flexible, you should make sure you read the terms carefully. Most will expect at least monthly repayments and charge penalties if this requirement is not satisfied.

    How do you apply for a line of credit?

    Eligibility criteria differs between lenders, so make sure to check this carefully before submitting your application. Be prepared with the following information, as most lenders have similar criteria for this part of the application:

    • Income. You have to show proof of an ongoing steady income. Payslips are usually acceptable or a bank statement which shows consistent deposits from an employer.
    • Liabilities. You will be asked to provide a complete list of your currents debts.
    • Expenses. So the lender can determine whether you have money available to make repayments, you will be asked to provide a summary of expenses and living costs. These include rent or mortgage payments, utilities, insurance and food costs.
    • Identification. All lenders want to see a current and valid photo ID of the applicant and in most cases, you will need to provide a photocopy for their records.
    • Assets. You need to provide information on property you own, plus cars, savings and investment accounts.

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