Lines of Credit

Difference between Pre-approved Loans and Credit Lines

The major difference is that a borrower applies for and receives a loan as a lump sum, while a credit line can be borrowed against, repaid, and then borrowed against again. For example, if your line of credit is $10,000 and you borrow $7,000 in January and pay back $5,000 in March, you are then eligible to borrow another $5,000, making the total borrowed amount $12,000 rather than $10,000.

This arrangement gives you much more flexibility than a set loan amount, but a high credit limit can easily lead to more borrowing than you really can afford.

How Lines of Credit Are Determined

When you first apply for a credit card, the credit card company assigns an initial credit limit based on your income and your credit history. If you have a good credit score and don't have a debt problem, your credit line will be set primarily according to your income and any other consumer debt or outstanding loans such as a mortgage. If you do have credit problems, then your line of credit will be much smaller.

After you've established a solid credit history with your credit card company, you can ask for your credit limit to be increased. However, too large a credit limit can make other lenders less likely to give you a loan, as it means you can take on more debt.

Banks and credit unions use much the same procedures for offering lines of credit. Lines of credit are useful for circumstances when you aren't sure whether or not you'll have a certain debt or what amount it might be, such as college costs. They are usually good for an extended period of time, often ten years. Sometimes when you apply, the interest rate is fixed for a certain period of time, usually ten to thirty days. After that initial period, it turns into a variable rate.

The variable rate is fixed against some kind of publicly available figure, such as the prime rate, the rate for US Treasury bills, or some other standard market measurement. The lender will add a certain amount to this, such as one percent over prime, and there should be a cap to the total interest rate you will pay. The total loan amount available to you may change based on the interest rate, with the loan amount declining as the interest rate rises.

Most lines of credit are secured against some kind of property, usually your home equity but sometimes against stock or other securities.

Application and Other Expenses

Credit cards don't typically charge more for cards with high lines of credit, as long as you are not a credit risk. Banks and credit unions, on the other hand, usually charge application fees. These fees include property assessment (if your credit is secured against your house), an application fee, and sometimes an annual maintenance fee.

Once you borrow against your credit, in addition to the principal and interest, you will usually pay a monthly fee, as well as fees for late payments. Just like credit cards, some lenders offer insurance against your death, becoming disabled, losing your job, or otherwise being unable to pay. Whether or not this is a good investment depends on how much the insurance costs are and the likelihood of your being unable to pay.

Advantages and Disadvantages

A credit line gives you flexibility to respond to an opportunity or an emergency at interest rates that are typically much lower than credit card rates. However, because lines of credit can be expensive to establish, it's not often worth it if you expect to repay the loan within a month or two, or unless you need to borrow a large enough sum that the interest rate will make a difference. You should also talk with your lender to compare the advantages and disadvantages of a personal credit line against a second mortgage..