A Line of Credit(LOC) is an attractive credit instrument offered by banks. We shall look at its features, benefits, and drawbacks before deciding its suitability.
Emergencies can come unannounced. Your house might need immediate repairs. You may need funds urgently for medical exigencies. Your children might secure admission to an Ivy League college. The possibilities are endless. Do you have the requisite resources to meet these exigencies? Yes, you can avail loans or insurance, but they might not be ideal. A Line of credit should be the perfect solution. We will explore this option and understand its importance.
What is a Line of Credit?
In simple terms, a Line Of Credit is an arrangement between a bank and the customer wherein the bank fixes a limit up to which the customer can borrow, not just in an emergency but even generally. This limit depends on various factors. We will look into these aspects in due course.
The Features of a Line of Credit
- The LOC allows the customer to access these funds as long as he does not exceed the limit.
- The customer need not use the entire limit at once. He has the liberty to withdraw depending on his needs.
- This is a revolving credit facility where the customer can repay the amount and restore the limit.
- As he withdraws from the account, his drawing power keeps on reducing. When he repays a part of the withdrawals, his drawing power increases.This is the concept of the LOC.
- The advantage of an LOC is that you pay interest only on the amount you borrow (outstanding balance) and not on the entire limit.
- The Line of Credit interest rate ranges from 10% – 15% depending on the creditworthiness and profile of the applicant.
Different types of LOC
· Security wise:
There are two types of LOC, Secured LOC and Unsecured LOC. As the name suggests, secured LOC envisages that the customer will provide collateral either in the form of mortgage of property, assignment of Life Insurance Policies, lien on Fixed Deposits, and other liquid security. The mortgage of property is the most common facility of all. As far as unsecured LOC is concerned, there is no collateral. The bank or the financial institution fixes up the limit depending on the credit history, income, and repaying capacity of the borrower. Naturally, the unsecured LOC attracts a higher rate of interest in comparison to the secured LOC.
· Facility wise:
Again, you have two types of LOC, personal LOC and Business LOC. It can be with or without security depending on the individual circumstances. The difference is in the utility of the funds. If you use it for personal purposes, it is a personal LOC and an LOC for business purposes is a business LOC.
Line Of Credit vs Loan
In a traditional loan, the bank makes the full disbursement to your account. You have to start repaying the installments according to the terms of the sanction. The repayment may start immediately or after a moratorium period depending on the sanction terms. This is irrespective of whether you use the amount. However, in the case of an LOC, you use the limit only when you need it. Hence, you will have to pay interest only on the amount you withdraw.
Factors determining the LOC:
Personal Line Of Credit
The factors governing a personal Line Of Credit are your income generation, continuity of income, credit history, and repaying capacity. The value of collateral is also an important factor if you opt for a secured LOC.
Business Line Of Credit
Banks usually sanction business LOCs with collateral. Certain banks sanction unsecured Line Of Credit if there is an underlying contract or a guarantee from the State or Central Government. The projected business turnover is an important factor. The profitability and the net worth of the business play a big role in determining the limit. Naturally, the business and the proprietors/partners/directors should have a good credit history.
Advantages of Line Of Credit:
- Flexibility is the key factor. You have the liberty to use the amount when you need it the most.
- You can repay the amount you have borrowed in case you have liquid funds. This restores the limit thereby allowing you to borrow again.
- You save on the interest component because you pay interest on the amount you have borrowed (balance outstanding).
- You do not have to make monthly repayments. Servicing the debt by paying interest would suffice. Hence, this is a great way to improve your credit history.
- The LOC is a convenient facility in the sense that you can withdraw the amount using checks, ATM cards, internet banking, and so on.
- You have a source of funds ready to cater to any emergency, since accessing the LOC is easy.
- An LOC is cheaper than a credit card or a personal loan. The rate of interest on the credit card (assuming you do not repay on time) and personal loan is higher than the rate of interest on an LOC.
Disadvantages of Line Of Credit:
- There are chances that you might misuse the funds because of easy accessibility. This can increase your interest burden.
- This is not the right facility for people who do not have a budgeted plan for expenses.
- In a traditional loan, you liquidate the principal amount over a period. This is not the case in an LOC. You can withdraw funds to the extent of your limit at any time.
Do you really need a Line Of Credit?
We have just seen how a Line of Credit can be useful. We have discussed the advantages of a Line Of Credit over traditional loans, credit cards, and personal loans. You are aware of the drawbacks of a Line Of Credit. This should help you make your decision whether you really need a Line Of Credit.
A Line of Credit is very useful to you in the following circumstances.
- You have a disciplined credit record.
- You foresee unexpected expenses cropping up in the future.
- You have adequate security to offer as collateral to the banks.
If you are adept at managing funds, then a Line of Credit is a good option.