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Understanding Personal Lines of Credit

Sep 11, 2020
By Mariclare Cranston, Content Specialist

What if you could get a loan that lets you access money only as you need it, instead of receiving (and paying for) a lump sum?

That is exactly what a Personal Line of Credit offers you. This variation of a Personal Loan provides you with a certain amount of money that’s available to use as you need, whenever you need it. We’re going to look at exactly what a Line of Credit is in detail, including:

How Does a Personal Line of Credit Work?

In some ways, a Line of Credit is similar to a credit card. You have a certain amount of money that you can use as you need it, but you don’t ever have to use it if you don’t need it. Like a credit card, you are approved for a certain amount, also known as your line. You can use any amount up to your available line.

At many financial institutions, when you open your Line of Credit, you begin the draw period. This is a defined length of time during which you may draw from, or use, your line. Some financial institutions, including MHV, allow you to keep your line indefinitely. You can access the money from your line as often as you need to throughout the draw period. As you use your Line of Credit, the amount you use is subtracted from the amount that you have available until you repay it.

For example, if you have a $2,500 Line of Credit and draw $500, you will have $2,000 left to access. As you pay that $500 back, though, it will again become available for you to use. You can continue to use, payback, and re-use the funds from your Line of Credit as often as you need to during the Draw Period. If you don’t use any of your line, you don’t have to make any payments.

Each financial institution will have specific guidelines for how long the draw period lasts. Some financial institutions, including MHV, keep your line open until you close it.

Once the draw period is over, the repayment period starts and you are no longer able to use your Line of Credit. Instead, you are responsible for paying back any of the outstanding balance on your line. The repayment period will have a set term, meaning you’ll have a defined amount of time in which to pay your Line of Credit back. At the end of your repayment period, or when your Line of Credit is paid off, it will be closed.

Does a Personal Line of Credit Impact my Credit Score?

Applying for a Line of Credit is just like applying for any type of loan. Your financial institution will check your credit when you apply. This is known as a hard pull. Hard pulls may temporarily decrease your score by a few points.

Once you’re approved for your Line of Credit, it will appear on your credit report as a new account. Once the line is open, its impact on your credit score depends largely on how you use it. If you don’t access the money, or only a small percentage of it, this can demonstrate a lower credit utilization, meaning you have more credit available to use. A lower credit utilization can help your credit score.

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If, on the other hand, you use the majority of the available funds, this increases your credit utilization and can negatively impact your score. And, of course, if you don’t make your payments on time you can also do damage to your score.

What happens when I pay my Line of Credit off?

You can pay your Line of Credit off and still keep the line open. Many financial institutions refer to this as paying your line down. You don’t have to close your Line of Credit if you pay it down; you have access to the funds for the duration of your draw period.

However, you can close your Line of Credit while still in your draw period once you pay it down to a zero balance. You may opt to do this if you’ve been struggling with making payments when you use the line or if you no longer need to access the funds. If you close your Line of Credit, keep in mind that if you do want to have access to funds again you will have to reapply for a new Line of Credit.

When Should + Shouldn’t I Use My Line of Credit?

There are definite benefits to having a Line of Credit. Many financial institutions allow you to use your line as overdraft protection. If you choose to use your Line of Credit in this way, your financial institution will automatically pull funds from your line to cover purchases you make that cost more than what you have available in your Checking Account. This helps you avoid having your card declined, running your Checking Account negative, and incurring insufficient fund fees.

Financial institutions often charge an insufficient fund fee when you try to make purchases that cost more than what you have available in your Checking Account.

A Line of Credit can also be used as an emergency fund. Because it will often have a lower interest rate than credit cards, it may make sense to pull funds from your line for unexpected repairs, medical costs, or other financial surprises.

If you’re anticipating a series of small expenses, a Line of Credit may be more prudent than a Personal Loan since you only make payments on the funds you use. If, however, you know exactly how much money you’ll need for a project, a Personal Loan may be a better choice. The interest rates on Personal Loans are typically a bit lower than Lines of Credit.

Personal Line of Credit Chart

You should not use a Line of Credit for your everyday expenses. Relying on credit for basic financial needs often indicates mounting financial hardship. If you find yourself in that position, other options are available for you, including:

Likewise, if your income isn’t steady or you’re already struggling to make all of your current monthly payments, adding an additional payment by using a Line of Credit could end up hurting you financially. Before applying for a Line of Credit, or any type of loan, take a look at your budget to ensure you can comfortably afford the additional payment.

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A Personal Line of Credit can be an effective financial tool. Like any financial decision, research your options, measure its affordability against your budget, and manage your line responsibly.

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