What Is a Line of Credit?
A line of credit is an amount of money that a lender offers to let you use when you need it, and that you will pay back over time with interest. But, you'll only pay interest on the amount of the line of credit you use.
Calculating Interest on Lines of Credit
When you take out a loan, you receive the entire amount of the loan upfront and the bank starts charging you interest immediately, regardless of whether you use all the money right away. Lines of credit, on the other hand, only charge you interest on the portion you're using. For example, a bank might tell you that you can borrow up to $5,000. If you only need $400 for a personal expense right now, you'll only pay interest on that $400. Next month, if you borrow another $500, you'll pay interest on $900.
Costs of a Line of Credit
In addition to interest, lines of credit may come with a maintenance fee, charged either monthly or annually, regardless of how if (if any) of the line of credit you're using at any given time. On the bright side, you can save time and cost because as long as your line of credit remains active, you can continue to use it without having to apply for a new loan each time you need some extra money.
When Lines of Credit are Beneficial
Lines of credit are most beneficial when you have an ongoing expense that you don't know how much you'll need to complete it. For example, say you're building a garage onto your home, will pay the contractors over time as the work gets done, and the eventual cost could be higher or lower than originally estimated. With a line of credit, you can take out the money as you need it to make the payments, but not pay interest on the entire amount up front.
Secured Versus Unsecured Lines of Credit
Some lines of credit are secured by property you own, such as your house being the collateral for a home equity line of credit. These lines of credit tend to have the lowest interest rate because the bank has a specific property it can seize if you don't pay the money back. Other lines of credit, known as personal lines of credit, don't have collateral. But, they charge higher interest rates because you're a bigger risk for the lender.