A personal line of credit is a flexible lending tool that gives you a set credit limit that you can draw on when you need it. It’s useful when expenses are irregular or difficult to predict, such as home repairs or inconsistent income from freelancers.
But that flexibility goes both ways.
“Personal lines of credit typically have higher interest rates than secured loans like mortgages or HELOCs,” said Craig Toberman, CFP and partner at Toberman Becker Wealth in St. Louis. “Rates typically range from 10% to 20% APR plus possible annual fees.”
Find out more about how this type of loan works and whether there is a more suitable alternative.
A personal line of credit, or PLOC, gives you access to funds up to a set limit. You withdraw money when you need it, usually by transferring funds to your checking account through an online portal or using checks issued by lenders. You are usually not issued a card.
Rates are usually variable. So if the prime rate moves, your monthly payment and overall cost of borrowing move with it; That’s good in a falling interest rate environment, but costly when interest rates are rising.
Read more: How the Federal Reserve Affects Consumer Loan Interest Rates
Rates also vary. Most lenders charge a monthly or annual fee, but some charge additional fees, such as:
Your interest rate may be variable, but the initial rate you receive ultimately depends on your credit score, your income, and your existing debt.
A personal line of credit usually has two distinct phases:
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Drawing period: You can withdraw funds freely. Minimum monthly payments are generally required. This period can last several years.
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Repayment term: Withdrawals are stopped. Monthly payments increase because you are now paying the balance plus interest in full.
The minimum payments on a personal line of credit are often just interest, said Melissa Cox, CFP at Future Focused Wealth in Dallas.
“That keeps your monthly bill low but it also keeps you in debt longer,” Cox added. “I’ve seen people carry balances for years without even realizing how much it’s costing them.”
Not all lenders use the same payment rules and terms may vary. For example, lenders may require you to pay back whichever is greater: $50 or 2.5% of what you borrowed. Some lines of credit even require a balloon payment at the end of the withdrawal period, where you must pay the entire balance in one lump sum.
That’s why it’s essential to understand payment terms before opening a personal line of credit.
Solvency is the most important factor in obtaining approval for a personal line of credit. Lenders want proof that you are a responsible borrower and can pay them back over time.
Before you apply, obtain your credit reports and check your credit score. Typically, a FICO score of at least 670 or higher is needed to get a decent rate, although some lenders may expect to see a score of 760 or higher.
If your score is below 670, work to reduce existing revolving balances and pay off late payments before applying.
In addition to your credit score and credit report, lenders also check your income, employment status, and debt-to-income ratio. Therefore, you will need to prove that you are earning enough money to pay back what you borrowed in a timely manner.
Banks, credit unions, and some online lenders offer personal lines of credit. Popular lenders include:
If your current bank or credit union doesn’t offer personal lines of credit, you’ll need to search online for one that does. Typically, you must first open an account at the bank before applying.
The application process is similar to applying for a personal loan or credit card. You will provide personal information such as your name and date of birth, details about your existing debts, along with employment and income documentation.
Most lenders run a thorough credit check when you apply for a line of credit, so be prepared for a temporary drop in your score.
Review and accept the offer.
Don’t rush this last step. Read every line of the loan contract, especially the payment rules. If a lender doesn’t clearly explain how your payment will change over time, that’s a red flag.
Before you sign, make sure you understand the following:
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Is the interest rate fixed or variable?
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How long is the drawing period?
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What happens when the drawing period ends?
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Is there an annual or inactivity fee?
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How is the minimum payment calculated?
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Does signing up for autopay reduce my rate?
Once you accept, your line of credit is activated and you will be able to begin withdrawing funds during the withdrawal period.
A personal line of credit can affect your credit score in several ways:
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Difficult investigation: When you apply, there is typically a heavy squeeze on your credit report, which can temporarily lower your credit score.
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Credit utilization: If you use more than about 30% of your line of credit, your credit score will likely take a hit, and the closer you get to your credit limit, the bigger the drop. Credit utilization is an important part of your credit score, so keeping your balance low is more important than the extensive research that goes into opening your line of credit.
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Payment history: Paying late or missing payments will lower your score quickly. Paying on time helps build credit.
When handled responsibly, a personal line of credit can help improve your credit score. But when used irresponsibly, it can just as easily damage you.
Read more: 8 Common Reasons Your Credit Score Might Go Down
Personal lines of credit are best for situations where expenses are unpredictable, such as:
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Home repairs or maintenance.
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Ongoing medical expenses
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Short-term cash flow gaps due to self-employment or seasonal work
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Wedding or large event planning costs.
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Moving and relocation expenses.
However, PLOCs should not be used when your budget is constantly underwater. If you treat the line of credit as extra spending money, you can quickly get into debt, Cox said.
“The catch is that it doesn’t feel like debt like a loan or credit card would,” Cox added. “But over time, it’s easy to fall into a cycle of using it more frequently than planned… Without a payment plan in place, it can quickly become financial quicksand: easy to get into, but hard to get out of.”
Do you need to borrow money? A personal line of credit is not your only option. Other types of loans and lines of credit are compared below.
Credit cards work best for everyday expenses if you can pay in full. You get a grace period to avoid interest and earn rewards. A PLOC charges interest immediately and offers no benefits, such as cash back or miles.
Credit cards typically have higher interest rates. Historically, PLOCs have lower fees, but they may also charge fees. Both credit cards and personal lines of credit have limits and cost you interest when you carry a balance.
A HELOC taps into the equity in your home, making it a secured line of credit. The lender has something to accept if you default, so interest rates tend to be lower than with an unsecured personal line of credit.
However, that lower cost comes with some important conditions. If you don’t make enough loan payments, you could face foreclosure. A PLOC doesn’t put your home at risk, but you will typically pay more interest.
“A personal line of credit makes more sense if you need faster approval without appraisal requirements, want to avoid putting your home at risk, or need a smaller line of credit that won’t justify the HELOC closing costs,” Toberman said.
Both personal loans and personal lines of credit allow you to borrow without collateral. The difference is how you access the money.
A personal loan offers you a lump sum up front. If you are approved for $25,000, that amount is sent to your bank account and you pay it in fixed monthly installments. It’s predictable and works well for one-time costs, but you’ll pay interest on the entire amount up front.
A personal line of credit acts more like a credit card. You only take what you need and can borrow again as you pay, up to your limit.
Personal loans typically have fixed APRs, which helps keep payments predictable. PLOCs typically use variable APRs tied to the prime rate, so they can start competitively but move with the market.
If you want payment stability, personal loans are probably the way to go. If you borrow briefly and rates remain stable or decline, a PLOC may be cheaper.
Read more: Personal Line of Credit vs. Personal Loan: Which Makes Sense for You?