Line of Credit
A line of credit is a flexible loan arrangement set up between a borrower and a financial institution, usually a bank. The bank extends a set credit limit that the borrower can draw funds from, much like a credit card. Borrowers can use as much or as little credit from their line as they need, and they only pay interest on the amount they use.
Lines of credit can be secured (backed by collateral such as a house or car) or unsecured (not backed by any collateral). Because unsecured lines of credit are riskier for lenders, they typically come with higher interest rates than secured lines of credit.
The two most common types of lines of credit are:
- Personal Line of Credit: This is typically used by individuals for large expenses or for consolidating higher interest debt. They are usually unsecured, and the borrower must have a high credit score.
- Business Line of Credit: This is used by businesses to manage cash flow, finance short term needs, or to fund unexpected expenses. Business lines of credit can be secured or unsecured, and the terms can vary greatly based on the lender and the financial stability of the business.
The main advantage of a line of credit over a regular loan is flexibility. Borrowers can draw on their line of credit at any time, up to the specified limit, without having to reapply each time they need funds. Furthermore, interest isn’t charged on unused portions of the line. However, lines of credit can have variable interest rates, which can increase the cost of borrowing if rates rise.
Example of a Line of Credit
Let’s consider a hypothetical example involving a business line of credit.
Let’s say Lisa owns a small landscaping company. Even though her business does well overall, she struggles with cash flow issues because her revenue fluctuates throughout the year – she earns most of her income in the spring and summer, and much less in the fall and winter.
To manage these cash flow challenges, Lisa applies for a $50,000 business line of credit with her bank. The bank approves her application, which means she now has up to $50,000 available to borrow when she needs it.
In January, Lisa decides to purchase new equipment for the upcoming busy season, costing $20,000. She draws this amount from her line of credit. She now owes the bank $20,000, plus any interest that accrues on this amount, but she still has $30,000 available to borrow if needed.
Over the next few months, Lisa uses the new equipment to complete several large landscaping projects, and she is able to pay off the $20,000 she borrowed plus the accrued interest.
In July, one of Lisa’s trucks breaks down unexpectedly. She needs $10,000 for the repair, so she draws this amount from her line of credit. Even after this, she still has $20,000 available if needed.
This example shows how a line of credit can provide flexibility for a small business owner like Lisa. She only borrows what she needs when she needs it, and she only pays interest on the amount she borrows. The rest of her line of credit remains available for future needs, without her having to apply for a new loan each time.
