A line of credit is a type of loan that gives you the ability to borrow funds up to a maximum amount. This is an alternative to a fixed loan. A credit line has advantages and disadvantages that you need to consider in order to use one successfully.
Secured or Unsecured
A primary consideration with a credit line is whether to use a secured or unsecured product. A secured credit line means you have put up your home, business or other property as collateral to assure repayment. You usually get much better financing rates on a secured loan since it minimizes the lender's risks. Of course, your risks are greater since you could lose your property. Some lenders will not offer you an unsecured personal credit line without you having a previous relationship and excellent credit score. If you are very comfortable with your ability to repay this debt, a home equity line of credit, or HELOC, may make sense.
Use as Needed
The ability to only borrow funds as needed is a major benefit of a credit line versus a fixed loan. This helps you when a flexible budget is necessary. Some home renovations, business expansions or other major events have less predictable and ongoing costs. Unfortunately, people often become over reliant on a credit line when budget discretion is more advisable. Using funds for non-essential, discretionary purchases is typically not good financial management since you have to pay back the debt with interest.
Know Your Terms
As with any loan, you should carefully review all terms before closing. Credit lines often have variable interest rates. This means your finance costs go up or down, depending on prime rates and other economic factors. Credit lines also commonly have draw periods during which you have open access to funds. Following the draw period, your remaining balance is converted to an amortized payment schedule, similar to a fixed loan. You also need to know about any annual account fees or other fees associated with having the line. Knowledge of terms enables you to best use your line to minimize your costs of borrowing.
Make Extra Payments
Another way to minimize your costs of borrowing is to pay down your loan balance as quickly as possible. You are charged interest based on your average balance each month. Making payments beyond the minimum is very helpful. Some lines are set up with interest only payments during the initial draw period. This keeps your monthly payments low, but you never pay down the equity without making extra principal payments.
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