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Understanding Line of Credit: Definition, Types and How it Works

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It’s a busy day and your car breaks down unexpectedly, or a limited-time sale on a dream vacation pops up, and you don’t have the cash on hand. These are the moments when a line of credit becomes a lifesaver.

Unlike a standard loan, you have access to funds whenever you need them, without having to reapply. You borrow only what you need and repay it at your own pace.

Think of it as your financial backup plan for emergencies or big opportunities. The beauty of a line of credit is that it's there when you need it, offering you flexibility and peace of mind. Whether it’s home repairs, unexpected medical expenses, or even that spontaneous travel deal, it’s a convenient way to manage life’s surprises without stressing about large lump-sum loans.

What is a Line of Credit?

A line of credit (LOC) is a flexible borrowing option that allows you to access funds up to a specified limit. Think of it as a financial cushion, you can withdraw money when you need it, and once repaid, you can borrow again. The amount you’re allowed to borrow depends on your creditworthiness, and the key advantage is that you only pay interest on what you use, not the entire limit.

How a Line of Credit Works

A line of credit provides flexible access to funds but operates differently from traditional loans and credit cards. Here’s how it works:

  1. Comparison to Personal Loan and Credit Card: Unlike a personal loan (which is a lump sum) or a credit card (which often carries higher interest rates), a line of credit allows you to borrow only what you need and repay over time.
  2. Revolving Loan Concept: Similar to a credit card, a line of credit is a revolving loan, meaning you can borrow, repay, and borrow again up to your set limit.
  3. Interest on Amount Withdrawn: You only pay interest on the amount you’ve used, not the entire credit limit. This helps minimize costs if you don’t need the full amount at once.
  4. Regular Repayment & Pre-Closure: Repayments are typically made monthly, and many lines of credit allow you to close the loan early without any penalties, providing added financial flexibility.

Understanding these features allows you to manage your line of credit effectively, offering financial breathing room without unnecessary costs.

Types of Lines of Credit

A line of credit provides ongoing access to funds, but the type of credit you choose depends on your specific needs. Let’s take a closer look at the options available and what to consider before choosing the right one.

1. Personal Line of Credit

A personal line of credit is a flexible borrowing option that allows you to access funds for various personal needs. It’s ideal for individuals who need quick access to cash without the constraints of traditional loans. This type of credit can be used for emergencies, unexpected expenses, or planned purchases like home improvements or medical bills.

Here’s what to consider:

  • Borrowing limit depends on your income and credit history.
  • Lower interest rates compared to credit cards.
  • Flexible access for personal expenses or emergencies, giving you financial breathing room when needed.

2. Home Equity Line of Credit (HELOC)

A HELOC allows homeowners to borrow against the equity in their homes, making it a popular choice for large expenses like renovations or debt consolidation. Your home secures the loan, so it offers higher borrowing limits and lower interest rates.

Consider the following with a HELOC:

  • Secured by your home as collateral.
  • Funds based on home equity, meaning the more equity you have, the more you can borrow.
  • Lower interest rates and higher credit limits due to the security provided by your home.

3. Business Line of Credit

A business line of credit is designed for business owners to manage operational costs and cash flow. It provides flexible access to funds that can be used to cover short-term expenses or business growth.

Here’s what you should keep in mind:

  • Secured or unsecured options available, depending on the lender.
  • Ideal for managing cash flow or handling unexpected expenses.
  • Unsecured lines may come with higher interest rates due to the greater risk for lenders.

4. Demand Line of Credit

A demand line of credit offers flexibility, but with the condition that the lender can demand repayment at any time. It’s a unique form of credit where repayment terms aren’t fixed, giving the lender significant control.

Consider this for flexibility, but note the risks:

  • Lender can request repayment at any time.
  • Repayment options may include interest-only or principal-plus-interest payments, depending on the agreement.

5. Securities-Backed Line of Credit (SBLOC)

An SBLOC allows you to borrow against your investments, such as stocks or bonds, without selling them. It’s a great option if you want liquidity without disrupting your investment portfolio.

Things to keep in mind for an SBLOC:

  • Uses investments like stocks or bonds as collateral.
  • Interest-only payments are required until the loan is repaid.
  • Keep your investments intact while accessing liquidity for other financial needs.

Evaluating your needs and understanding the types of lines of credit available, you can choose the option that best aligns with your financial goals and circumstances.

Secured vs. Unsecured Lines of Credit

A secured line of credit requires collateral and offers lower interest rates but risks asset loss if unpaid. An unsecured line of credit doesn’t need collateral but comes with higher interest rates and lower borrowing limits. Each option fits different financial needs.

1. Unsecured Line of Credit

An unsecured line of credit doesn't require any form of collateral, making it more accessible to a wider range of borrowers. However, lenders will rely heavily on your financial background, so keep the following in mind:

  • No Collateral Required: You don’t need to pledge assets like your home or car.
  • Approval Based on Credit and Income: Lenders assess your credit score, income, and overall financial stability.
  • Higher Interest Rates: Since there's no collateral, lenders take on more risk, resulting in higher interest rates.
  • Lower Borrowing Limits: Typically, unsecured lines offer lower limits compared to secured ones.

Example: Suppose you're approved for an unsecured line of credit of ₹1,00,000. While you don’t need to offer collateral, your interest rate might be around 15%, higher than a secured loan, and your borrowing limit could be lower than if you had pledged an asset.

2. Secured Line of Credit

A secured line of credit is backed by assets, offering several advantages, such as lower interest rates and higher borrowing limits. However, the risk is that if you default, the lender can seize your collateral.

  • Collateral Required: You must provide a valuable asset, such as a house or car, to secure the loan.
  • Lower Interest Rates: Because the lender’s risk is reduced, you can benefit from lower interest rates.
  • Higher Borrowing Limits: Secured lines typically offer higher borrowing limits since they are backed by assets.
  • Risk of Asset Loss: If you fail to make payments, the lender can seize the asset you’ve used as collateral.

Example: If you take a secured line of credit using your home as collateral, you might get a limit of ₹5,00,000 at a lower interest rate, say 8%. However, if you default, the lender can claim your home to recover the loan amount.

Secured lines of credit are ideal for those who can provide collateral and want to take advantage of lower rates, while unsecured lines work best for those who don’t want to risk their assets but are prepared for higher rates.

Revolving vs. Closed-End Lines of Credit

When it comes to lines of credit, there are two key types: revolving and closed-end. Each works differently and offers distinct benefits based on your needs.

1. Revolving Line of Credit (Open-End Credit)

A revolving line of credit allows you to borrow, repay, and borrow again, providing continuous access to funds. Here's what to know:

  • Borrow repeatedly up to the credit limit.
  • Interest is charged only on the outstanding balance, not the entire credit limit.
  • Ideal for ongoing expenses or financial flexibility.

Example: Let’s say you’re approved for a ₹3,00,000 revolving line of credit. You borrow ₹50,000, repay it, and then can borrow the ₹50,000 again without reapplying. Interest is charged only on the ₹50,000 you used.

2. Closed-End Line of Credit (Non-Revolving Credit)

A closed-end line of credit is more structured, with a fixed amount borrowed for a specific purpose. Once repaid, you can’t borrow again without reapplying.

  • Fixed amount for a defined purpose, like buying a car or funding a project.
  • Repayment may involve periodic payments or a lump sum, depending on the agreement.
  • Once repaid, the line is closed, and you must reapply to borrow again.

Choosing between these options depends on whether you need continuous access to funds or a one-time loan for a specific need.

Example: You take out a ₹2,00,000 closed-end loan to renovate your home. Once it’s repaid, the loan is closed, and if you need more funds, you must apply for a new loan.

Let’s understand what are the major differences between a loan and a line of credit. Keep scrolling through!

Differences Between a Loan and a Line of Credit

Loans and lines of credit may sound similar, but they serve very different financial purposes. Let’s break down their key differences to make it easier for you to decide which one is right for your needs.

Loan

A loan provides you with a one-time lump sum of money for a specific purpose, such as buying a car or funding a home renovation. Once you receive the loan, you start paying interest on the entire amount, regardless of how much you use at once.

  • Example: If you take out a ₹3,00,000 loan to buy a car, you immediately begin paying interest on the full ₹3,00,000, even if you haven’t spent it all yet.

And remember if you need a loan quickly, Pocketly has you covered! With fast approvals and instant disbursal, you can get the cash you need in just minutes. Simplify your financial emergencies!

Line of Credit

A line of credit is much more flexible, allowing you to draw, repay, and redraw money up to a certain limit. The best part? You only pay interest on the amount you’ve actually used, not the total limit.

  • Example: Suppose you’re approved for a ₹5,00,000 line of credit. If you withdraw ₹1,00,000, you’ll only pay interest on that ₹1,00,000 until you repay it and borrow again if needed.

Both options serve different needs, depending on whether you require a lump sum for a specific goal or ongoing access to funds.

Limitations of Lines of Credit

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While lines of credit offer flexibility, they do come with some downsides. Understanding these limitations can help you manage your borrowing more effectively and avoid potential pitfalls.

Here are some important limitations to consider.

Higher Interest Rates

Lines of credit generally carry higher interest rates compared to traditional loans, especially if unsecured, which can make borrowing more expensive.

Rising Interest Payments

If you only make interest payments and don’t repay the principal, your overall debt will increase over time.

Risk of Asset Seizure

For secured lines like a HELOC, failing to repay can result in losing your home or other collateral.

Potential for Serious Debt

The ability to borrow repeatedly can lead to a cycle of debt if you’re not careful with repayments.

Lender Can Change Terms

Lenders have the right to alter the terms, such as reducing your credit limit or raising interest rates, often based on your financial situation or creditworthiness.

Understanding these factors ensures you use your line of credit responsibly, balancing flexibility with caution.

Things to Keep in Mind While Using Lines of Credit

Using a line of credit can be incredibly helpful, but it requires a thoughtful and strategic approach. Here's what to keep in mind to ensure it works to your advantage:

  1. Avoid Overuse: The ease of access might tempt you to borrow more than needed, leading to increased debt and repayment challenges.
  2. Watch Out for Variable Interest Rates: Interest rates can fluctuate, which means your borrowing costs could rise unexpectedly.
  3. Be Cautious with Collateral: If your line of credit is secured, missing payments could risk your assets, such as property or equipment.
  4. Know the Limits: The credit limit might not be enough for larger expenses, so consider alternative financing for big investments.
  5. Fees and Charges: Be mindful of any associated fees—annual, transaction, or maintenance fees—that can add up over time.
  6. Impact on Credit Score: Maxing out your credit or missing payments can damage your credit score, affecting your future borrowing capacity.

Keeping these factors in mind, you’ll ensure that your line of credit stays a helpful tool rather than a burden.

How Does a Line of Credit Affect Credit Score?

A line of credit can influence your credit score both positively and negatively, depending on how you manage it. Here’s what to keep in mind:

  • Positive Impact: Keeping your balance low compared to your credit limit and making on-time payments demonstrates responsible credit usage and boosts your score.
  • Negative Impact: Over-utilising your credit, carrying high balances, or missing payments can lower your credit score, signaling potential financial stress to lenders.

By using your line of credit responsibly, you can maintain or even improve your credit rating over time.

If you want to learn more about the credit score and how to get a loan, check out our guide on Getting Personal Loan with Low CIBIL Score.

Advantages of Line of Credit

A line of credit provides flexibility, but it’s essential to weigh both its advantages and disadvantages. Let’s break it down to help you understand when it can work best for you.

  • Pay Interest Only on What You Use: Unlike traditional loans, where interest is charged on the entire loan amount, with a line of credit, you only incur interest on the funds you actually withdraw. This feature allows for cost-effective borrowing, especially if you don’t need to use the full credit limit.
  • Flexible Repayment Options: A line of credit gives you the freedom to repay the borrowed amount at your own pace. As long as you cover the interest payments, you can repay the principal when it’s convenient for you, making it ideal for those with fluctuating cash flows.
  • Reusable Credit: Once your line of credit is approved, you don’t need to reapply each time you want to borrow. As long as you stay within your credit limit, you can borrow, repay, and borrow again as needed. This makes it a convenient, ongoing financial tool.
  • Helps Build and Boost Your Credit Score: Responsibly managing your line of credit, by making timely payments and keeping your usage within the recommended limits, can positively impact your credit score. Over time, consistent usage can improve your creditworthiness, making it easier to access future financial products at better.

When considering a personal loan, you probably start thinking about eligibility, repayment terms, and how it will impact your credit score. But what if we told you there’s a way to get a personal loan with minimal hassle? With Pocketly, the process becomes even simpler. Ready to learn how? Check out the section below!

Apply for a Personal Loan with Pocketly

Applying for a personal loan through Pocketly is quick and effortless, making it perfect for those in urgent need of funds. Let’s break it down:

1. Download the Pocketly App:

Start by downloading the Pocketly app from the Google Play Store or Apple App Store.

2. Sign Up or Log In:

If you're new to Pocketly, just sign up with your basic details. If you're already a user, simply log in.

3. Enter Basic Information:

Fill in the essential details like your name, mobile number, Aadhaar number, and PAN card number. Pocketly keeps the process simple, so you don’t have to dig through a pile of documents.

4. Submit Necessary Documents:

You’ll need to upload your Aadhaar card, PAN card, and proof of income. Don’t worry; this can all be done through the app, so it’s quick and seamless.

5. Complete KYC and PAN Verification

To verify your profile, upload your KYC and PAN details. This is an important step to ensure your identity is confirmed and your loan can be processed smoothly.

6. Verification and Approval:

Pocketly will quickly verify your details. Once verified, you’ll receive an approval notification via email or SMS.

7. Select Loan Amount and Tenure:

Choose the loan amount and select a tenure that suits your repayment plan. Pocketly gives you flexibility with terms so you can pick what works best for you.

8. Loan Disbursement:

Once approved, the loan amount will be directly transferred to your bank account—usually within a few hours!

With minimal documentation and fast processing, getting a loan on your Aadhaar card has never been easier!

Conclusion

A line of credit offers incredible flexibility, whether you’re managing everyday expenses, handling emergencies, or planning for the future. With the ability to borrow, repay, and borrow again, it’s a great tool if used responsibly. However, understanding its limitations and potential risks is key to ensuring it remains a helpful financial resource.

Looking for a fast, simple way to access funds? Pocketly makes personal loan applications easy, quick, and hassle-free. Download the app now and get instant access to the money you need, when you need it!

FAQs

What is a Line of Credit and How Does It Work? 

A line of credit (LOC) is a flexible borrowing option allowing you to withdraw funds up to a set limit, repay, and borrow again. Interest is only charged on the amount used, not the entire limit.

What Are the Different Types of Credit and Their Definitions? 

Types of credit include:

  • Revolving Credit: Borrow, repay, and reborrow up to a limit (e.g., credit cards, LOC).
  • Installment Credit: Borrow a lump sum and repay in fixed installments (e.g., personal loans).

How Does a LOC Work? 

A LOC allows you to draw and repay funds up to a predetermined limit. You can access the credit repeatedly, and interest is only paid on the amount used.

What is a Line of Credit Classified As? 

LOCs are classified as revolving credit, similar to credit cards, because they allow continuous access to funds.

What is a Line of Credit Example?

If you're approved for a ₹2,00,000 LOC, you can borrow ₹50,000, repay it, and borrow ₹50,000 again as needed, with interest charged only on what you’ve borrowed.

How Can I Apply for a Personal Loan on Pocketly? 

Simply download the Pocketly app, complete the easy sign-up process, submit minimal documentation, and get quick approval. The funds will be disbursed directly to your bank account.

What Makes Pocketly Different for Personal Loans? 

Pocketly offers a fast, hassle-free application process, with minimal paperwork and instant disbursal, making it ideal for quick cash needs.