What Is a Personal Line of Credit?

A personal line of credit can be an ideal financial solution if you're financing a significant expense, like a home renovation. It offers the flexibility to draw funds as your project progresses, aligning well with the varying stages and expenses of home renovation. Instead of taking out a large sum upfront, as with a traditional loan, you can access the amount you need when you need it, paying interest only on what you use.

However, a personal line of credit isn't a one-size-fits-all solution for every financial need. MoneyGeek broke down how a line of credit works and weighed the benefits against the drawbacks to help you determine if this option aligns with your particular circumstances.

When you qualify for a personal line of credit, the lender gives you a credit limit, which often ranges from $1,000 to $50,000. This limit depends on factors like your credit history and income. You can access funds up to this limit by transferring the money to your checking account, writing checks directly from the line of credit or using a card provided by your lender. This makes it convenient for managing unexpected expenses or ongoing projects.

During the draw period of a personal line of credit, which can span several years, you have the freedom to access your funds. Plus, you only have to pay interest on the amount you borrow.

Personal lines of credit have three main types of repayment methods:

• Draw and Repayment Period: This option allows you to withdraw funds during a set "draw period," typically a few years. Note that the funds you spend can be available for borrowing again if you repay the principal in addition to interest, as long as the draw period hasn't ended. Once the draw period ends, you start paying back the principal (the amount you borrowed) and the accumulated interest.
• Balloon Payment: With this method, you make smaller payments during the life of the line of credit. At the end, you pay a large “balloon” payment, covering the remaining balance.
• Demand Line of Credit: While less common, this type gives the lender the right to call the loan due at any time. You must repay the full amount upon their request.

Understanding your lender's repayment terms lets you plan effectively, ensuring you responsibly manage your line of credit and avoid financial difficulties.

Understanding where you can use a personal line of credit will help you maximize its benefits. We highlight some of the common uses for them below.

• Home Renovations and Improvements: Due to its flexibility in fund access, a personal line of credit is ideal for home renovation projects where costs can be unpredictable. It allows homeowners to withdraw funds as needed for various stages of the project. This feature prevents borrowing more than necessary, as you would with a lump-sum loan.
• Emergency Fund: A personal line of credit serves as an excellent emergency fund for unexpected expenses like medical bills or car repairs. The ability to draw what you need when you need it makes it a practical option for emergencies. Moreover, you only pay interest on the amount you use, making it a cost-effective emergency resource.
• Travel and Large Purchases: For significant expenditures like travel or high-value purchases, a personal line of credit can provide the necessary funds without the high interest rates of credit cards. Its flexibility allows for borrowing exactly what is needed, plus the typically lower interest rates can make it more economical than other credit options.
• Cash Flow Management: A personal line of credit can be an effective tool for managing cash flow, especially for those with irregular income patterns, such as freelancers or small business owners. It allows access to funds during lean periods to cover expenses or invest in opportunities, ensuring financial stability. The flexibility to draw from the line of credit as needed and only pay interest on the amount used makes it a practical solution for smoothing out cash flow fluctuations.
• Moving Costs: Relocating can be expensive, involving hiring movers, transportation and temporary lodging. A personal line of credit provides the flexibility to cover these varying expenses as they occur. This adaptability helps manage the unpredictable costs of moving, allowing for a smoother financial transition to your new home.

A personal line of credit is a flexible financial tool, and knowing the various applications can help you make informed decisions about when and how to use it effectively.

Different lenders have their own sets of fees associated with personal lines of credit. Be aware of these fees before you move forward, as they can significantly impact the total cost of your line of credit. These include:

• Origination Fees: This is a one-time fee some lenders charge when you open a personal line of credit. It covers the cost of processing your line of credit application and is typically a percentage of your credit limit.
• Application Fees: Some lenders charge an application fee to cover the costs of evaluating your creditworthiness. This fee is usually required when you apply and is not refunded even if your application is not approved.
• Late Payment Fees: If you miss a payment or make a late payment, you will likely be charged a late payment fee. This fee encourages timely payments and can vary in amount.
• Maintenance Fees: Some personal lines of credit come with a fee for maintaining the account. This fee is charged yearly or monthly, separate from the interest you pay on borrowed funds.
• Transaction Fees: Whenever you withdraw funds from your personal line of credit, you might be charged a transaction fee. This fee is usually a small percentage of the amount withdrawn.

These fees can add up and affect the affordability and suitability of a personal line of credit for your financial needs. As such, always read the fine print and ask your lender to clarify any fees before agreeing to a line of credit.

Before pursuing an application, weigh the benefits of a personal line of credit against its drawbacks. This balanced assessment can help you determine if this option aligns with your financial needs and goals.

You can typically obtain a personal line of credit from traditional banks, credit unions and select online lenders. Each of these lenders offers distinct advantages and conditions, so understanding the differences will help you choose the best option for your needs.

• Traditional Banks: Traditional banks are a common source of personal lines of credit. They often offer the benefit of in-person customer service and the possibility of integrating your line of credit with other banking products. However, they might have stricter eligibility requirements and charge higher fees than other lenders.

• Credit Unions: Credit unions are member-owned institutions known for their more personalized customer service. They generally offer lower interest rates and fees for personal lines of credit than traditional banks. However, to access these benefits, you need to become a member of the credit union, which often involves living, working or studying in a specific area or being associated with a particular group.

• Online Lenders: While not all online lenders offer personal lines of credit, those that do provide a convenient and fast online application process, often with less stringent eligibility criteria than traditional banks. However, the lack of physical branches means you won't have in-person support, which is something to consider if you prefer face-to-face interactions for your banking needs.

Deciding whether a personal line of credit suits you involves carefully evaluating your financial situation and needs. We highlight some steps to help clarify if this option is right for you.

• Assess Your Financial Needs: Consider what you intend to use the credit for. A personal line of credit is ideal for ongoing, variable expenses or unexpected costs. If your financial needs are unpredictable or you face expenses you can't cover with savings, a line of credit might be a suitable option.
• Examine Your Spending Habits: Reflect on your financial discipline and spending habits. A personal line of credit requires self-control as it's easy to access funds. As such, ensuring you won't be tempted to overspend is helpful. A line of credit can be a valuable financial tool if you have a history of disciplined spending and debt management.
• Understand the Fees: Familiarize yourself with the potential fees associated with a personal line of credit, such as annual fees, origination fees or penalties for late payments. Compare these costs with other credit options. Understanding these fees assists you in assessing the overall cost-effectiveness of a personal line of credit for your financial situation.

By utilizing the above strategies, you can make an informed decision that aligns with your financial goals and circumstances.

A personal line of credit may not be the ideal solution for everyone. We recommend exploring alternatives to find the best option that aligns with your needs and financial situation. These include:

Understanding personal lines of credit can be tricky, especially for consumers who have never used them before. We answered frequently asked questions that may help clarify your concerns.

MoneyGeek defines common terminology that often comes up when learning about personal lines of credit.

• Creditworthiness: An evaluation of a borrower's likelihood to repay debts; significant in determining eligibility for a personal line of credit.
• Credit Limit: The maximum amount of credit a lender will extend to a borrower on a line of credit.
• Credit Report: A detailed report of a borrower's credit history, considered by lenders when assessing a line of credit application.
• Draw Period: The period during which a borrower can withdraw funds from their line of credit. The borrower can repeatedly draw funds up to the credit limit during this period.
• Default: Failure to meet the repayment terms of the line of credit, which can result in penalties and affect credit ratings.
• Hard Credit Inquiry: A lender's check on a borrower's credit history as part of the line of credit approval process, which may affect the borrower's credit score.
• Minimum Payment: The lowest amount of money you must pay on your line of credit statement each billing cycle to keep the account in good standing. Minimum payments usually only include accrued interest and not principal amounts.
• Principal: The original sum of money borrowed on a line of credit, not including interest.
• Repayment Period: During this phase, you pay the outstanding balance by repaying the principal amount you borrowed and any accrued interest. You can make no further withdrawals during this period.
• Secured Line of Credit: A line of credit that is backed by collateral, reducing the risk for the lender and often resulting in a higher credit limit and lower interest rate for the borrower.
• Unsecured Line of Credit: A line of credit that does not require any collateral (such as property or other assets) for approval.
• Variable Interest Rate: An interest rate on a line of credit that can fluctuate over time based on underlying benchmarks or indices.