How a line of credit or LOC works
What is a line of credit?
A personal line of credit (LOC) is a type of revolving loan that allows you to access up to a preset amount of money. You are charged interest on the amount of money that you draw from your LOC. These types of credit are offered by lenders, including credit unions, banks, and other financial institutions.
Most financial institutions and banks have qualifications for people to be approved to borrow the funds such as having a certain credit score. A line of credit allows people to flexibly borrow money up to a maximum amount during a set period of time.
American debt
According to data from the Philadelphia Federal Reserve, Americans hold a little more than $1 trillion in outstanding revolving debt. Revolving debt includes credit card debt and unsecured lines of credit, among others. In addition, Americans hold nearly $3 trillion in nonrevolving debt such as vehicle debt, student debt, medical debt, mortgages, and others.
Revolving debt differs from nonrevolving debt. It allows you to borrow up to a certain amount at your convenience and is not tied to making specific types of purchases.
Nonrevolving debt includes credit that is secured by property that you are buying or personal financing in specific amounts that must be used to purchase specific items. When you repay nonrevolving debt in full, the credit available to you is extinguished. With nonrevolving debt, the amount of credit that is available to you is replenished when you repay what you have borrowed.
How do lines of credit work?
If you are approved for a line of credit, you will only be charged interest at the time that you borrow money from it. Once you have repaid the amount that you have borrowed, that amount will be available again to you.
This type of credit provides access to flexible borrowing. You are able to choose when you borrow money and when you pay it back. As long as you adhere to the terms, you will be able to continue borrowing money. The terms might include making timely payments and repaying the amount that you borrowed in full.
Loan vs. line of credit
The following table outlines the general differences between various loans and lines of credit.
Loans v. LOCs
| Personal loan | Personal line of credit | Home equity loan | Home equity line of credit | Business loan | Business line of credit | |
|---|---|---|---|---|---|---|
| Amount | Up to $50,000 but can be more | Up to $25,000 to $50,000 | Based on equity in home | Based on equity in home | Up to $5 million | Up to $1 million |
| Interest Rate | Fixed | Variable | Fixed | Variable | Fixed | Fixed or variable |
| Base rate | 5% to 36% | 8% to 24% | 3.2% to 7.5% | 3.5% to 6.7% | 5% to 30% | 5% to 40% |
| Term | Up to 5 years | Open-ended term | 5 to 30 years | 10 years followed by repayment period | 1 to 20 years | Revolving with annual renewals |
The advantage a revolving line of credit has over a normal loan is that it does not have to be used for a specific purpose and no interest is charged on unused amounts. You will only be charged interest on the funds that you withdraw.
With a loan, you receive a lump sum of money to make a specific purchase. You must begin paying interest immediately regardless of when the money is used. By contrast, a credit line provides you with access to a set amount of money. You can borrow the money that you need when you need it and you will not be charged interest until you actually take out the money.
A credit line allows you to borrow money in increments. You can repay what you borrow and borrow again as long as it stays open. You will have to pay interest on your borrowed balance while your credit line is open. Loans instead have fixed installment payments that require payment at set dates.
Secured credit
Secured credit is a credit that is backed by your personal or real property. If you fail to make the payments, your lender can take the asset that secured your credit line.
A home equity line of credit or HELOC uses your home as the collateral for your credit line in a similar way as a second mortgage. You are able to borrow money against the equity that you have available in your home. It has a variable rate of interest, which means that your payments might increase over time. If you have a HELOC, you should only borrow the amount that you need instead of taking a lump sum.
HELOCs limit the amount that you can borrow. You may be able to borrow up to 85% of the appraised value of your home minus the amount that you have remaining on your first mortgage. When the HELOC rates are set by the bank, the bank will take into account your credit score, credit history, and income. The HELOC rates that you pay may be tax-deductible.
Securities-backed lines of credit or SBLOCs are special LOCS that are backed by borrowers’ securities. The securities that you hold serve as collateral for the credit line. You can borrow anywhere from 50% to 95% of the value of the assets in your account.
Borrowers are not allowed to use the money from their SBLOCs to trade or purchase securities. However, they are able to use the money for nearly any other purpose. SBLOCs require borrowers to make monthly, interest-only payments until the loans are fully repaid or the brokerage demands payment. This can happen if the value of an investor’s portfolio dips below the credit line’s level.
Unsecured credit
An unsecured line of credit has unique terms. The limits can range from a few thousand to several hundred thousand dollars. Some unsecured lines of credit come with annual fees. Since the lender is taking on more risk, the interest rates can be higher than the rates for a secured line.
Personal lines of credit provide you with a specific amount of money up to a certain limit that can be used for any purpose as you need. These come with lower interest rates than credit cards, making them a better choice for borrowing. They offer flexible access to money instead of a lump-sum payment for a single purpose. To get a personal line of credit, you will need a good credit score and a history of repaying your debts on time.
Revocable credit line
A revocable credit line is a credit line that is provided to an individual or business by a financial institution or bank. It can be canceled or revoked at the lender’s discretion. A bank might revoke the credit line if the customer’s financial circumstances worsen or if market conditions warrant a cancellation. It can be secured or unsecured.
Revolving credit
Revolving credit refers to an open-ended credit account. It allows borrowers to spend money, repay it, and spend it again in a revolving cycle as long as your line of credit remains open. Revolving credit lines are different from installment credit.
With closed-end credit accounts, you are allowed to borrow a set amount of money and then have to make payments in equal installments until you have repaid it in full. Once you have paid off the installment loan, you will not be able to spend the money again unless you submit a new application. Examples include mortgages, car loans and signature loans.
Nonrevolving credit
For nonrevolving credit, you can use the money for a number of purposes after the credit limit has been established. Interest will be charged, and the payments can be made at any time.
The amount of available credit funds does not replenish after you make the payments unlike with revolving credit. After you have repaid the nonrevolving line of credit in full, the account will be closed and cannot be used again.
Line of Credit Fees
A line of credit may come with fees, including an annual fee and limits on how much you can borrow. During the repayment period, you repay the principal and interest on the amount that you borrowed. For a HELOC, you may also pay closing costs similar to a home equity loan. These can vary and will depend on your lender.
Examples of other lines of credit
A business line of credit offers credit for businesses on an as-needed basis. Financial institutions will evaluate the market value, risk, and profitability of a business before agreeing to extend it a business line of credit. The line may be unsecured or secured, depending on the size of the requested line of credit and the overall evaluation of the business. The interest rate is variable.
A demand line of credit may be secured or unsecured. For this type of credit line, the lender may call in the payment at any time. The terms of payment may vary widely, ranging from interest-only payments to interest plus principal. A borrower of this line of credit is able to spend up to the credit limit at any time. These types of credit lines are uncommon.
Things to watch out for
There are several things that you should look out for if you are thinking about applying for a line of credit. Unsecured lines of credit have higher rates of interest and more stringent requirements than secured lines of credit.
The interest rate is nearly always variable for a line of credit and vary widely from one to another. Before you apply for a credit line, you should read the terms carefully for severe penalties for late payments and for going over the limit. If you do get a credit line, use the funds wisely. If you misuse them, it can hurt your credit score.
Taking out a line of credit
A LOC offers you a flexible way to borrow money. Before you apply, check your credit scores and take steps to boost them so that you can qualify for a lower APR. Once you have been approved for a LOC, you will have a drawing period during which you will be able to take money from your credit line. This period can last for several years.
Figure out the amount of money that you need and what you intend to spend it on. You may be given a card or checks to use to access your credit line by the bank or financial institution. Alternatively, the funds might be transferred to your checking account upon your request.
When you take out money, the interest will begin to accrue. You will be required to make at least the minimum monthly payments. The amount that you pay in your payments will be added back to your available credit line so that you can access it again. It is not advisable to only make the minimum payments because doing so may cost you more money in interest payments in the long-term.
After your drawing period ends, you will enter the repayment period. You will then have a set period of time to repay your remaining balance of the principal and interest.
Comparing a LOC to M1 Borrow
A line of credit requires a credit check and additional paperwork. It is possible that you may be denied. The interest rates will vary and depend on your credit score and credit history, and they may be fairly high.
M1 Borrow is a portfolio credit line that allows you to borrow up to 40% of the value of your taxable brokerage account. The interest that you will be charged is among the lowest rates in the industry at 8.25%, or 6.75% if you’re a Plus member. You do not have to fill out any additional paperwork or undergo credit checks. For people with qualifying taxable accounts, there are no denials.
Flexible portfolio line of credit with M1 Finance
Investors place their trust in M1 Finance and M1 Borrow because they can access the easiest, lowest-cost way to borrow money. M1 Borrow’s flexible portfolio line of credit lets you borrow up to 40% of your portfolio and to pay it back at a low interest rate on your schedule.
Borrow money at any time while paying one of the lowest interest rates available. You can pay down expensive debt with M1 Borrow instead of taking out a second mortgage or borrowing against the equity of your home with a HELOC. It also has other tax advantages when compared to a home equity line of credit.
M1’s platform was created in such a way that investing is accessible to all types of investors. When you open an investment account with M1 Finance, you can customize it to meet your goals or select from among dozens of portfolios that have been created to fit a variety of different objectives, times to invest, and abilities to tolerate risk. Investing with M1 is free as the brokerage does not charge any management fees or commissions when you invest your money.
The powerful platform also helps to save time by automatically reinvesting and rebalancing your portfolio. This helps to keep you and your money on track to meet your financial objectives automatically.
Tax and Legal Advice Disclaimer. M1 Finance and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice.
Margin Disclaimer: Using margin involves risks: you can lose more than you deposit, you are subject to a margin call, and interest rates may change. To learn more about the risks associated with margin loans, please see our Margin Disclosure. M1 Borrow available on margin accounts with a balance of at least $2,000. Does not apply to retirement accounts.