What Is a Line of Credit and How Does It Work?
A line of credit is a flexible borrowing arrangement. A lender approves a maximum amount, the credit limit, and you draw money from it when you need it, up to that ceiling. Interest is charged only on what you have drawn, not on the whole limit, and as you repay, the available credit is restored.
Banks and credit unions offer lines of credit to individuals and businesses, secured or unsecured. The sections below explain the parts of a typical arrangement, the main types, and how a line compares with a loan or a card. Terms vary a great deal between lenders and countries, so read the agreement in full and consider professional advice before signing.
The parts of a line of credit
Credit limit
The credit limit is the most you can owe at any one time. Lenders usually set it after looking at income, existing debts, credit history and, for secured lines, the value of the collateral. A limit is not fixed for life: the lender may raise or lower it during the account's life, as the agreement allows.
Draw period
Many lines have a draw period during which money can be taken out. Payments in this phase may be interest-only or a small percentage of the balance, depending on the product.
Repayment period
Some lines, home equity lines in particular, switch to a repayment period when the draw period ends. No new draws are allowed and the remaining balance is repaid over a set term, which can mean noticeably higher monthly payments. Other lines simply stay open and are reviewed or renewed from time to time.
Interest rate
Rates on lines of credit are often variable, tied to a benchmark rate plus a margin. When the benchmark moves, so does the cost of whatever balance is outstanding.
Main types
| Type | Secured? | Typical use |
|---|---|---|
| Personal line of credit | Usually unsecured | Uneven or occasional personal expenses |
| Home equity line of credit (HELOC) | Secured by property | Larger costs such as renovations |
| Business line of credit | Either | Bridging the gap between paying suppliers and being paid by customers |
| Overdraft line on a checking account | Usually unsecured | Covering occasional shortfalls in the account |
| Savings-secured line | Secured by a deposit | Borrowing against one's own savings |
With a secured line, the lender holds a claim on the collateral if repayments stop. The guide to secured and unsecured borrowing explains what that means in practice.
How a line of credit works day to day
- The lender approves the line and sets the limit.
- You draw funds by transfer, card or check, depending on the account.
- Interest starts on the drawn amount, usually from the day it is taken.
- A statement shows the balance and the payment due.
- Repayments reduce the balance and free up the limit again.
Because the balance can rise and fall repeatedly, a line of credit is a form of revolving credit. The comparison of revolving vs installment credit shows how that differs from a loan paid out in one go.
Line of credit vs loan vs credit card
- Compared with a personal loan: a loan pays out one lump sum with fixed repayments and an end date. A line is more flexible, but its final cost is harder to predict.
- Compared with a credit card: both revolve. Cards are built for purchases and often include a grace period; lines are usually drawn as cash and may charge interest from the first day.
- Compared with short-term property finance: a bridging loan is a lump sum for one specific gap, such as waiting on a property sale, rather than an open facility.
Costs and risks
- Arrangement, annual or maintenance fees on some accounts, and occasionally a fee per draw.
- Variable rates that can climb while a balance is outstanding.
- A jump in payments when a draw period ends.
- For secured lines, the risk to the asset if payments are missed.
- The ease of drawing money, which can turn a safety net into long-term debt.
Applying and your credit file
An application normally involves a hard credit check. Once open, the line is reported like other accounts in many credit systems, so paying on time and keeping the balance moderate relative to the limit both count.
Questions and answers
Do I pay interest on an unused line of credit?
Interest is normally charged only on drawn amounts, though some lines carry fees whether or not they are used.
Can a lender reduce or close a line?
Yes, within the terms of the agreement. This can happen if the borrower's circumstances change or the collateral loses value.
What is the difference between a credit limit and available credit?
The limit is the ceiling. Available credit is the limit minus the current balance and any pending draws, so it shrinks as you borrow and grows as you repay.
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