A personal line of credit is a loan you use like a credit card. A lender approves the entire amount at once, but you pay interest only on what you use.
A personal line of credit can be a useful tool when you need to borrow money incrementally, such as paying contractors for an ongoing home improvement project. It can also help you avoid overdrawing your checking account when you have an irregular income or use auto-pay and run into an unusually large bill.
Unlike a home equity line of credit, or HELOC, a personal line of credit requires no collateral. It’s based solely on your credit history. You’ll need good credit, typically credit scores of 680 or higher.
How a personal line of credit works
A lender preapproves you to borrow up to a certain amount, but unlike a loan, you don’t necessarily draw the full amount immediately. You access the funds over time, as you need them, via electronic transfer or by writing a check.
You pay interest only on the amount you’re using, not the full amount. Interest rates are variable and typically tied to the U.S. prime rate. The line of credit may also have an annual fee, and generally you have to pay the fee regardless of whether you use the available funds.
Interest rates may be comparable with or lower than those you can get for credit cards. For example, Wells Fargo recently offered personal lines of credit at an annual percentage rate of 7.25% to 20%, with discounts of up to a percentage point for people who have other accounts there; the annual fee is $25. US Bank’s APRs were 9.5% to 13.5%, without an annual fee. It pays to shop around. The law requires lenders to give you APR information, so you’ll be able to compare offers.
Payment is typically structured like a credit card, where repayment begins right away. As with credit cards, there is not a set payment, but rather a minimum. However, some personal lines of credit may be set up more like a HELOC, where there’s a draw period and then a later repayment period, says Nessa Feddis, senior vice president and deputy chief counsel for the American Bankers Association.
A personal line of credit is reported as revolving credit on your credit report, says Rod Griffin, director of public education for credit bureau Experian. That means using too much of your credit line could hurt your scores.
How they differ from other forms of credit
A personal line of credit differs from a traditional personal loan in that you don’t have set payments over a specific repayment period. That type of loan, called an installment loan, is reported differently on your credit report. If you know how much money you will need in total and you need it all at once, a personal loan may serve you better than a personal line of credit.
A personal line of credit is “unsecured,” meaning you don’t put up collateral the lender can seize if you don’t repay. That differs from a HELOC. With a HELOC, the loan is secured by your house, and the lender can repossess it for failure to repay — but you get a lower interest rate. (Some financial institutions offer lower interest rates if you have a savings account or CD there and use the money in that account to secure your line of credit.)
Unlike credit cards, a personal line of credit requires a “prime” credit score, Feddis says. The precise definition of prime can vary by financial institution, but in general prime credit scores start around 680 on the 300-850 scale used for VantageScores and most FICO score models. Each institution sets its own criteria for qualifying.
The pros of a personal line of credit
- You avoid paying interest on the full amount before you need it.
- If your income is uneven, you can use the credit line to cover bills while waiting to be paid.
- Interest rates are likely to be lower than for a personal loan (but as always, check to be sure).
- Because you can write a check, you may be able to get a discount from businesses that do not accept plastic or want to avoid credit card fees.
- You can tap the line as a source of emergency funds.
- Having a separate account accessible only if you write a check or transfer funds may help you stick to a budget or control your spending.
The cons of a personal line of credit
- A line of readily accessible credit could be dangerous if you tend to overspend.
- Interest rates are higher than for loans secured by your home or by money on deposit with the bank offering the line of credit.
- Many have an annual fee, regardless of whether you use the credit.
- Because they’re revolving credit, like credit cards, they don’t diversify your mix of credit accounts like an installment loan would.
- They may be hard to qualify for if you don’t apply when your finances are in great shape. If the emergency you would like to cover with a personal line of credit has already occurred, you might not qualify if your income or credit has suffered.
When an alternative might be better
Depending on the bill(s) you are paying, credit cards or a HELOC are worth considering.
A HELOC will almost certainly have a lower interest rate, but if you become unable to pay, you could lose your house. It might be better for a major home improvement, though, where you believe you’ll recover the money and more if and when you sell.
If your credit score is good enough to get a personal line of credit, you likely also qualify for good credit card offers. You may be able to access the same amount of money at an even lower interest rate by opening a card with a low introductory rate or interest-free balance transfers. Just keep in mind how much you may need to charge; carrying a credit card balance higher than 30% of your limit can damage your score.
If your need is primarily to avoid accidentally overdrawing your checking account, you’re looking for a credit product that is “automatically and only accessed through the checking account,” Feddis said. “A line of credit could be accessed through the checking account, but only if the customer takes the initiative to transfer funds from the line of credit to the checking account. It isn’t automatic.” So while a bank or credit union’s overdraft protection service may cost more than a line of credit, its automated function may suit you better.
Keep in mind you don’t have to pick just one tool for all of your credit needs. A 0% balance transfer card can be great to pay for something when you know you can pay off the balance before the offer expires. But it’s not the right tool if you’re looking to buy a car.
Bev O’Shea is a staff writer at NerdWallet, a personal finance website. Email: firstname.lastname@example.org. Twitter: @BeverlyOShea.