All you need to know about credit line

What is a Line of Credit And How Does it Work

A line of credit is an arrangement between a bank / financial institution and you, the borrower. It allows you to maintain a maximum loan balance account with the lender and is referred to as a “line of credit account”. You can access funds from this continuous revolving credit account by entering an agreement with your lender and agreeing to the terms of borrowing, including a maximum threshold limit up to which you can borrow. Some of the terms which are laid out include a minimum monthly payment to be made or a specific tenure. The ongoing nature of the revolving credit account is what makes it easy to access and utilise continuously.

A line of Credit vs Loan

The basics of a personal line of credit are very similar to that of a personal loan. Both are credit instruments which allow you access to funds based on a repayment interest rate. However, in a loan, a lump sum amount is disbursed for your usage at one time and interest is charged on the entire amount that is lent to you, irrespective of whether you use up that entire amount or not. In contrast, a Line of Credit makes a revolving amount of money available to you to borrow and interest is charged based on how much of that amount you actually utilise rather than on the total funds allocated to you.

Another difference is in the interest rate. The line of credit’s interest rate is generally higher than a loan yet the closing costs for a line of credit are generally lower than that of a loan. The credit line interest rate ranges somewhere between 10.5% to upwards of 14-15%. Also, the monthly payments for a line of credit are generally lower than a standard loan, making it a more affordable option on a monthly basis.

Flexibility is also in the form of the open-ended nature of a line of credit. A loan is generally given for a specific purpose, for example, home loan or car loan etc. A line of credit may not involve a specific purpose and you can use the funds for whatever purpose you wish, within the demarcation of the personal credit line and business credit line.

A line of credit is thus, a more flexible option than a loan, but because of the higher interest rate may turn out to be costlier in the long term.

Types of Line of Credit

A line of credit can basically be of two types based on the collateral backing - secured and unsecured.

1. Secured Line of Credit: In a secured line of credit, you get the loan against a collateral that you place as security. The lender can seize or liquidate your asset if you default on your payments.

2. Unsecured Line of Credit: An unsecured line of credit is “a revolving credit account for funds withdrawal which does not require you to place any asset as collateral”. Unsecured line of credit rates generally varies as per varying bank interest rates. They are floating interest rates.

Depending on the purpose for which the line of credit is used, it can be classified as a personal line of credit and business line of credit.

1. Personal Line of Credit: Typically used for meeting expenses of an urgent and immediate nature or long-drawn expenses, such as a sudden financial need or a family function. The application is personal in nature.

2. Business Line of Credit: Used for funding your business expenses, often of an ongoing nature, such as working capital requirements, wage payments, purchase of raw materials and inventory etc.

There are also some lines of credits that serve a very specific purpose, such as the following:

• Home Equity Line of Credit (HELOC): A secured credit line backed by the home owned by the borrower. It is usually available for a set time period, typically this “drawing period” is about 10 years, after which the borrower must make full payment. HELOC  is often used for home repayments, improvements, emergency fixes etc.  

Who Should Opt For a Line of Credit?

A line of credit arrangement is commonly used by businesses to offer customers the privileges of flexibility and funds-access at the same time. This also helps businesses streamline their “working capital” requirements and helps them manage their current account funds in order to finance their current assets (like raw materials or wages).

People often wonder what lines of credit can be used for in the personal context. It can be used to fund emergency needs such as a medical event or even a major event like a wedding in the family. Some people also use lines of credit as a consolidation loan to pay off credit card debt, though this may not be a great idea.

How Do You Get a Line of Credit?

A number of banks offer lines of credit loans for both personal and business use. Applying for a line of credit is not a complicated process. It is, in fact, very similar to a loan, depending on whether it is business / personal or secured / unsecured. Firstly, it is important that you find out your eligibility for a credit line by knowing and assessing your creditworthiness. Next, you have to submit a number of financial documents (personal or business), along with your credit score to the lender. These will be assessed by your lender to determine your eligible amount and other terms such as tenure. When you apply for a personal line of credit your personal creditworthiness is scrutinised, whereas when you apply for a business line of credit, your business financials and status is checked. It is best to check with your regular bank/lender with whom you have an ongoing relationship, in order to increase chances of your line of credit application being accepted.

Requirements For Credit Line Application in India

An unsecured line of credit does not involve any guarantor asset which is pledged against the loan. It poses a greater financial risk to the lender than a secured line of credit. In fact, you may look at an unsecured line of credit as a form of an unsecured loan, which typically involves stringent approval processes and strict assessment of the “ability to repay the credit”. Generally, you need to meet the following criteria to be able to avail an unsecured line of credit.

• Age between 25-55 years.

• Salaried professional with respectable financial credentials, working at a public or private organisation (in case of personal LOC).

• Meet the net monthly income criteria of the lender, which may vary from lender to lender.

• For business, the business has to be in existence for a certain specified time period (which is usually one year) and must have a minimum turnover amount.

• A good creditworthiness i.e. good credit score / CIBIL score

Of course, there is a host of documentation required to process an unsecured line of credit application - salary slips, bank account statements, proof of employment or business documentation such as financial statements, identity proof, address proof etc.

To apply for a personal line of credit that is secured, you have to pledge any of your assets as collateral. The line of credit amount will depend on the value of the collateral. This is in addition to the above documentation.

As a general rule, it is easier to get a secured line of credit than an unsecured one. This is because the bank has the collateral to fall back upon, even in the unfortunate incident that you are unable to make your repayments.

Advantages of Credit Line

• Flexibility: Because of the revolving nature of the credit account, the credit account will technically be always available, at any time. This works well for businesses where the expenses cycle may be seasonal and not regular, the businessman can tap into the funds as and when the need arises. This means that you are eligible for a large credit amount, but need not utilise it all. Also, repayment terms can be flexible, from part payments to lump sum.  

• Inexpensive: In a line of credit arrangement, you need not pay the interest on the entire amount lent. You have to pay interest only on the amount that you actually use, in the said time frame. This reduces the cost of lending, especially in cases where the fund utilisation is not high.

• No Charges For Drawing Money: There are generally no charges for withdrawal of funds, which may not be the case with other kinds of credit instruments (like credit cards charge a fee for cash withdrawal against credit card).

• Higher Account Limit: Although loans and credit cards function in a similar manner, a line of credit loan comes with a higher account limit than a credit card. This makes it favourable for tackling large expenses such as weddings.

• Unsecured: Most lines of credit loans are unsecured i.e. no collateral backing is required to take a line of credit loan. So even if you do not have any financial backing, you can start your business or pay for your personal commitments easily by making use of a line of credit.

• Lower Interest Rate Than Credit Card: Despite being similar to a credit card, the interest rate is often much lower than a credit card, making a line of credit a cheaper credit option than a credit card.

Disadvantages of Credit Line

• Because of the unsecured nature of a credit line, the interest rates may fluctuate as per the bank interest rates. You may end up paying much more interest than what was agreed upon at the outset, making the entire arrangement quite expensive.  

• Revolving Cycle: A line of credit works like a revolving account. However, if you do not keep track of the repayment amount due, it is easy to lose track and keep drawing from the account (despite the specified limit).

• Stringent Approvals: A line of credit is approved only after checking creditworthiness, hence those with poor credit history may find it almost impossible to get one.

• Closing And Maintenance Costs: Some banks may issue closing costs to close down a line of credit or maintenance charges to keep them running. Check for these to minimise extra expenses.

• No Tax Benefit: The interest on a line of credit is not tax-deductible unlike some loans like a home loan and education loan.

How do You Increase Credit Limit in Line of Credit?

Like most credit instruments, lines of credit lets the borrower increase their account limit. Many people often rack their brains on how to increase the limit on the line of credit. There are various means to increase the line of credit limit. One of the ways is to request for a line of credit limit increase with your lending institution. If opting for this approach, the key question to ask yourself here is, “Does requesting a credit limit increase hurt my credit score?” The answer is yes, it may.

Requesting an increase in a line of credit limit may trigger a “hard enquiry” into your credit report, This means that your lender will scrutinise your creditworthiness by re-evaluating your CIBIL score. Too many hard inquiries into your CIBIL score can hurt your credit score and can have a negative impact on your creditworthiness and future borrowing capacity.

On the other hand, if you have a very good repayment reputation or an increased income, you may be eligible for an automatic credit limit increase. This is one of the best ways to increase your credit limit because it means that your lender trusts you and treats you as a valued and reliable customer. You are one of those customers who will seldom default on repayments on your line of credit. On the flipside, not repaying your line of credit dues can lead to a reduction in your line of the credit limit and really damage your creditworthiness.

New Age Options For Increasing Line of Credit Limit

Nowadays, there are a number of options to choose from when it comes to availing a line of credit. Fintech companies are emerging in the form of online lenders and offering a plethora of credit options. Borrowers can avail the facilities based on their unique requirements. Maintaining an ongoing relationship with such online lenders is easy because it is completely virtual and hence, location-agnostic. MoneyTap is one such player in this field launched in 2016, they were the first one to provide a personal line of credit in India. They understand the modern consumer needs and it caters to specific needs, such as a greater line of credit limit. You can download their credit line app here.

A line of Credit is a relatively new credit instrument that is fuelling the dreams of many people. It is imperative that you inform yourself with the right knowledge about this worthy instrument so that you can decide to utilise it wisely and make the most of this financial means.