What is a Line of Credit and How Does a Line of Credit Work

A line of credit is a loan product offered by financial institutions that enables you to borrow up to a specific limit, provided you qualify.

You may withdraw funds whenever needed for any purpose, as long as you don’t go over your account limit.

Similar to regular loans, you must repay the principal amount and any interest charges incurred.

Credit lines provide a flexible and convenient way to borrow money for significant expenses, such as education fees, home renovations, or a new vehicle.

Moreover, they serve as a valuable source of credit in emergencies or as a means of consolidating debt.

If you’re seeking an affordable financing option with flexible repayment terms, you should consider applying for a line of credit.

How Does a Line of Credit Work?

A line of credit provides you with direct access to funds through a financial institution, usually a bank or credit union.

You can borrow money through your account any time you wish up to a predetermined limit by either withdrawing cash from an ATM or through your online banking.

Some lines of credit can even be linked to your debit card.

There’s no set repayment schedule to follow, as a credit line is an open-ended loan product.

However, much like a credit card, there’s a requirement to pay a minimum amount each month, usually consisting of interest charges.

Your financial institution will send you a monthly statement showing your outstanding balance and the minimum payment required.

Line of Credit Interest Rates

The most crucial aspect to understand about lines of credit is that they come with variable interest rates.

With a variable rate product, the interest rate you pay fluctuates based on changes in the prime rate.

The prime rate is the rate lenders charge their most creditworthy clients – it acts as a benchmark they refer to when they assign rates on variable-rate credit products.

Since your line of credit’s rate moves in tandem with the prime rate, your interest costs can increase or decrease over time.

For example, the quote “prime + 5.00%” means that the rate you’ll pay will be whatever the prime rate is at the time plus five percent.

If the current prime rate is 3%, interest will be charged at 8% percent.

Should the prime rate increase a year later by half a percent, your new rate will be 8.5%.

In addition to the prime rate, many other factors determine the interest rate a lender sets on your line of credit account.

Lenders review your credit report to assess the risk of extending credit to you.

Suppose they deem you a high-risk borrower based on what they discover.

In that case, they will assign you a higher rate as compensation for the risk they assume.

Alternatively, suppose you have a history that showcases an ability to handle credit responsibly.

In that case, they’ll reward you with a lower rate.

Your income sources, assets you own, and other debt your carry also play a role in determining your rate.

These details provide lenders with insight into your ability to service repayments on your line of credit.

If they don’t like what they see, they’ll set you up with a higher rate or reject your application altogether.

Lenders calculate and apply interest charges monthly, which is the standard billing period for a line of credit.

Here’s how the process works in practice, using the average daily balance method:

Step 1: The dollar value of each purchase is multiplied by the number of days left in the billing period.

Step 2: Each amount is divided by the number of days remaining in the billing period, which results in an average daily balance for each purchase.

Step 3: The average daily balances are summed.

Step 4: Any unpaid balance is then added to the summed average purchases, and any payments made are subtracted.

Step 5: The resulting figure is then multiplied by the interest rate to determine the interest charge at the end of the billing period.

There are other methods financial institutions can employ to calculate interest charges, but the average daily balance method is a common one.

Now that you have an overview of how interest works on a line of credit, what kinds of rates can you expect should you decide to apply for one?

For a personal line of credit, typical rates are prime + 4%.

If you possess a solid credit score and your finances are in good order, you can potentially secure lower rates.

You can expect to find similar rates on student lines of credit.

For a home equity line of credit (HELOC), you can secure rates at 3% or lower with a traditional lender like a bank or credit union.

That’s assuming, of course, your credit profile is in stellar shape.

Secured vs Unecured Lines of Credit

It’s important to understand the difference between a secured vs unsecured line of credit.

A secured line of credit requires pledging an asset you own as collateral.

Should you default on your repayments, your lender can legally take possession of the asset and liquidate it to cover the shortfall.

The benefit of this arrangement is that you’ll be able to negotiate a lower interest rate for your line of credit, as the asset functions as security for the lender.

An unsecured line of credit isn’t secure by any asset you own – it’s backed simply by your promise to repay the debt owing.

While there’s no danger of your lender acquiring your assets, they will impose a higher rate to compensate for the increased level of risk they must bear.

Common Types of Lines of Credit

Personal line of credit

This is the most common line of credit available for borrowers.

You can use it for various purposes, such as covering an unexpected expense or financing a home renovation.

A personal line of credit is generally unsecured, meaning you can expect higher rates than those offered on the secured variety.

Still, they’re a cheaper alternative to credit cards and some personal loans, as well.

Provided your finances are in great shape, and you have a steady income, you’ll have access to the lowest rates available on the market, as well as a high credit limit.

Student line of credit

A student line of credit is geared specifically for individuals attending a recognized post-secondary institution, either full-time or part-time.

It helps students cover the cost of their tuition, textbooks, and living expenses.

Much like a personal line of credit, it’s an unsecured product.

Unlike a student loan, you only borrow as much as you need through a student line of credit, which allows for flexibility.

The interest on this credit line begins accruing once you draw funds from it.

Depending on the loan contract, you may also have a grace period of six to 12 months upon graduation.

However, you can choose to make payments earlier than that.

Home equity line of credit (HELOC)

A HELOC is a secured line of credit backed by your home.

As such, it offers very low rates, sometimes only slightly above the prime rate.

To be eligible, you need to have a certain amount of equity in your home, typically a minimum of 20%.

A HELOC generally provides you with a sizable credit limit – up to 65% of your property’s value is not uncommon.

Though your home equity backs a HELOC, acting as security for the lender, the application process can still be tedious and requires you to pass the financial stress test.

When you first borrow funds through a HELOC, known as the draw period, you’re required only to repay a minimum amount each month, consisting of interest charges.

Once a certain amount of time has elapsed, the repayment period begins, where you must commit to timely repayments of the principal.

Lady On Laptop Researching Line Of Credit

Frequently Asked Questions

  • Is the interest rate on a line of credit annual?
  • Does a line of credit have a fixed interest rate?
  • No, lines of credit have variable interest rates, which is one of their defining features. A shift in the prime rate will precipitate a change in the interest rate on your line of credit. Your total interest cost could wind up more or less than initially anticipated depending on how it moves.

    When it comes to HELOCs, sometimes your lender provides an option to convert a portion of your outstanding balance to a fixed rate. This type of product is essentially a hybrid of a HELOC and home equity loan.

Mark Gregorski

Mark is passionate about educating people on how the financial markets work and providing tips to help them better manage their money. Mark holds a bachelor’s degree in finance from the Northern Alberta Institute of Technology and has more than a decade of experience as an accountant.

Outside of writing and finance, he enjoys playing poker, going to the gym, composing music, and learning about digital marketing.