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What Is a Line of Credit?

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This guide will cover how lines of credit work and how you can apply for one. By the end, you'll know whether it's the right financing option for you.

What is a line of credit?

A line of credit is a preset amount of money that you can borrow from as needed. The lender sets the credit limit, and you only pay interest on the amount that you borrow.

The difference between a loan and a line of credit is the greater flexibility a line of credit offers. When you get a loan, you'll receive the entire loan amount up front. The lender will start charging you interest on that amount right away, and you'll need to make fixed payments.

With a line of credit, you can borrow up to the credit limit at any time. As you pay down your balance on a line of credit, you'll also open up more available credit, and you can borrow from it again if you want.

There are two types of lines of credit:

  • Secured line of credit: A line of credit where the borrower puts up assets as collateral. One of the most common examples is a home equity line of credit (HELOC), where the collateral is the borrower's home. If the borrower fails to repay a secured line of credit, then the lender can repossess the collateral.
  • Unsecured line of credit: A line of credit without any collateral attached. Since the lender is taking a greater risk, unsecured lines of credit often have lower credit limits and higher interest rates.

How does a line of credit work?

With a line of credit, you're allowed to borrow as little or as much as you need -- up to the credit limit set by your lender. You only pay interest on the amount you borrow. As you repay your balance, more credit comes available.

Let's say a lender approves you for a $25,000 line of credit. You withdraw $5,000. The lender will start charging interest on just that $5,000. They'll also set a minimum amount you must repay every month. You'll still have $20,000 left in available credit.

Now, let's imagine that you've paid back $3,000. You could then borrow up to $23,000 from your line of credit because your available credit increases as you pay off your balance.

When a lender approves you for a line of credit, it will set all the terms, including:

  • Credit limit: The maximum amount that you can borrow.
  • Interest rate: The fee you pay on any money you borrow. Most lines of credit have variable interest rates that can go up or down depending on the market. Some lenders also offer fixed interest rates.
  • Draw period: The length of time that you can borrow from the line of credit.
  • Repayment period: The length of time you have after the draw period to finish paying off your balance.
  • Fees: Some lenders may charge a monthly or annual fee for a line of credit.

As you may have noticed, a line of credit works in a very similar way to a credit card. A line of credit has three advantages:

  1. Interest rates tend to be much lower on lines of credit than on credit cards.
  2. Lines of credit generally offer higher credit limits than credit cards.
  3. You can get cash from a line of credit. Although many credit cards offer cash advances, these usually have even higher interest rates, so it's smarter to only use a credit card for purchases.

If you only need a secure payment method that can help you build credit, then opening a credit card is the way to go. But if you need to borrow money, you're better off with a line of credit.

How to get a line of credit

Here are the steps you can follow to get a line of credit:

  1. Work on your credit score: Your credit score is a key factor when you apply for a line of credit. It affects whether the lender approves your application and what interest rate and credit limit you will get. You should check your credit score before applying and see if there are steps you can take to raise it, such as paying down any credit card balances you have.
  2. Decide if you want a secured or unsecured line of credit: You could get a much lower interest rate with a secured line of credit. To do this, you use your assets, such as your home, car, or even a savings account, as collateral. Offering collateral will also improve your chances of being approved -- especially if you don't have a good credit score. Just remember that the lender can repossess your collateral if you default on your line of credit.
  3. Find a lender that offers lines of credit: A good place to start is your current bank or credit union, since you already have a financial relationship there. You should also shop around with other banks and financial institutions to compare your options.
  4. Choose an amount: During the application process, you'll need to request an amount. Think about how large a line of credit you want. Look at the minimum and maximum amounts that different lenders offer to help you decide.
  5. Fill out an application: The application process can vary by lender, but most will let you apply online. Expect to provide information on your income and assets (even if you're applying for an unsecured line of credit).

The lender may make a decision on your application right away, or it may need time to review it.

How to use a line of credit

Once you've been approved for a line of credit, you can make withdrawals. The way you do this depends on the lender. Many lenders transfer withdrawals directly to your bank account. There are also lenders that offer debit cards or checks you can use.

You'll receive your minimum payment amount and due date from the lender after you make a withdrawal. As you borrow more or repay your balance, your minimum payment amount will change.

Be careful about how much you withdraw from your line of credit. You'll be paying interest on each withdrawal, so it's not a good financial decision to use a line of credit -- or any form of credit -- for frivolous purchases. Whenever possible, you should also pay more than the minimum amount. You'll get your balance paid off more quickly and with less interest this way.

Is a line of credit right for me?

A line of credit can be a great choice if you need to finance large expenses or have an income that fluctuates from month to month.

If you have one or more big purchases coming up and you're not sure exactly how much they'll cost, a line of credit is ideal. You can withdraw as much as you need when you need it. A loan wouldn't work as well, because you could end up borrowing more or less than necessary. Here are a few examples of times when a line of credit is helpful:

You can also use a line of credit to help with cash flow if your income is different every month. Maybe you're a freelancer with clients who don't always pay as promptly as you like, or you're a business owner and sales vary quite a bit by season. In either case, a line of credit gives you a financial safety net when you need it.

Still have questions?

Here are some other questions we've answered:

FAQs

  • A line of credit is a financial product that allows you to borrow from a lender whenever you need money, up to a set credit limit. You're only charged interest on the amount you withdraw, and you can make multiple withdrawals as long as the line of credit is open and you haven't reached the credit limit.

    As you repay the balance on your line of credit, you can reuse it. For example, you have a $10,000 line of credit, and you borrow the full $10,000. After you repay $5,000, you would be able to borrow up to $5,000 again.

  • After you've applied for a line of credit and been approved, you can borrow from it whenever you want. Lenders typically send these withdrawals through bank transfers.

    The lender will set the credit limit (the maximum amount you can borrow) as well as the interest rate. You'll only pay interest on your withdrawals, rather than the whole balance. The lender will also determine the length of time that you can borrow from your line of credit. This is called the draw period.

    When you make withdrawals, you'll receive a statement listing the current balance, the minimum payment amount, and the payment due date. You must pay the minimum amount on or before the due date. If you want, you can pay more than the minimum.

  • You can use a line of credit for anything you want -- there are no restrictions on how you use the money. Consumers often choose lines of credit for large expenses that don't have a fixed cost, such as home improvement projects. A line of credit is helpful when you don't know exactly how much money you'll need or when you'll need it. If approved, you'll have access to funds without committing to borrow any specific amount.

  • To get a line of credit, start by finding a lender that offers them. Many banks and credit unions do, and you may find that your current bank does as well. Check the lender's minimum and maximum line of credit amounts to decide how much you'll request. When you're ready, fill out an application either online or in person.

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