What is it?
A line of credit (LOC) is another credit product where you may use borrowed funds at a lower rate and there is no interest-free grace period. That means as soon as you use your LOC, it instantly accrues interest. The rate varies but is usually between 2%-12%. The lowest rate you can get is at P. P just stands for prime rate which means this the lowest rate the bank is willing to offer you when lending money. Exceptions are mortgages but I won't discuss that here. LOCs are also commonly used as emergency funds over savings accounts because of their easy access to cash. Being a credit product, these are some things they have in common with credit cards:- Need to be approved (you need good credit)
- Can be used to build credit score
- Has required minimum payment
The funds from a LOC is flexible and can be used for whatever you want. Ideally, if you are planning on carrying some debt, it's better to use a LOC instead of a credit card because you'll be saving payments on interest. The only downside is you won't collect any points. I've recommended to past clients with credit card troubles to pay off their credit card debts using their LOC. Their interest rate dropped from 20% to 10% and they couldn't be happier. I should also quickly mention that anytime I mention a rate, it's always annualized. This means that's the rate for the entire year. Refer to the ODP post if you forgot.
Keep in Mind
As with other credit products, here are some things you should keep in mind when getting one:
- Interest rate - What is the interest on your LOC?
- Limit - What is the limit of your LOC?
- Minimum payments - When and what are the minimum payment requirements on your LOC?
- Fees - What other fees are there?
- Purpose - What are you using it for?
LOC are popular because of their lower interest rates relative to ODP or credit cards. They're also a good option if you want to consolidate all your high-interest debt, given that you have room. If you are consolidating your debts using a LOC, don't use your LOC to pay off your low-interest debt. The only time that makes sense is when your LOC's interest rate is the lowest.
For example, in the following 2 scenarios:
Scenario 1:
- Credit card special offer - $5,000 (8%)
- LOC - $3,000 (12%)
DON'T consolidate your lower credit card into your LOC. You'll end up paying more in interest.
Scenario 2:
- Credit card - $5,000 (20%)
- LOC - $3,000 (5%)
DO consolidate your higher credit card into your LOC. You'll end up saving money in interest.
Home Equity Line of Credit (HELOC)
Another type of line of credit is the HELOC. They also provide flexibility but the only difference between this and regular LOCs is that they draw from the equity of the house. They function in the same way as regular LOCs do. The only limitation is that you can't take out more than 65% of the equity of your home. You are essentially taking out the value that you've built into the house and using it for whatever you want. Most people would use HELOC for renovations, repairs and consolidation of debts because interest rates on HELOCs are close to the low rates of mortgages. Upon selling your house, you would need to repay the equity you took out with interest. Otherwise, your lender will take the equity that you took out.
See you next week!
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