A lot of us might know (or think we know) about credit cards and lines of credit, but when should you use them & why?
Here are a few things I wish I knew about lines of credit vs. credit cards and when to use each of them.
What is a line of credit?
Simply put, a line of credit is a loan that lets borrowers borrow money for any reason up to a set limit, and 9 times out of 10 you will have interest to pay along with your payments.
You can use however much money you need (up to the limit), and you will have to pay interest on the amount you borrow.
Usually, there isn’t a deadline you have to pay your line of credit back so you can usually pay it off as fast or slow as you want to as long as you make the minimum monthly payments.
So how does it work?
If you need to open a line of credit, this isn't financial advice but I would say you need to talk to your current bank or credit union, they’ll usually give you some of the best interest rates.
When you call your bank or credit union, remember to ask them if they are going to run your credit, it’ll usually be a soft pull if they do - sometimes it’ll result in a hard pull once you accept the loan,
also ask them about any fees they’ll charge to open the account, like a registration or admin fee.
Once you get approved for your line of credit, they’ll usually ask you how you want to receive it. You can usually:
Write a check from your line of credit
Withdraw cash from your bank or ATM
Have them deposit it right into your account
Every month you will get a statement telling you how much you owe on the loan.
You need to pay a minimum monthly payment which is usually the monthly amount of interest - but, there is no deadline for paying back the full amount.
Remember though, when you pay the minimum amount that really means you’ll never really pay off the debt.
Interest rates vary depending on the type of line of credit you open but they are usually variable, which means your rate can & likely will change over time. I wrote more about this in our personal finance book.
Most of the time, when you apply for a personal loan your credit plays a big role in what your interest rate is. People with higher credit scores might get offered lower interest rates since they are seen as more credible than someone with lower credit.
A few types of lines of credit:
Secured line of credit
For this type of credit line, you use an asset— like your car— as collateral. If you don’t pay back the loan your asset can be taken by the lender. Ever heard of someone getting “repoed”? That’s what they're referring to.
Since you’re backing a secured loan with collateral, you’ll usually get a lower interest rate than you would using some other types of credit lines.
Home equity line of credit (HELOC)
This secured line of credit is when you put your home up as collateral.
HELOCs usually have low-interest rates and high credit limits.
Know this though, if you don’t pay back your HELOC, you can lose your house - known as foreclosure. This is why it is important to make sure you don’t borrow more than you can handle or for a reason not really worth it.
Unsecured line of credit
This kind of line of credit isn’t backed by any collateral.
Personal and student lines of credit are examples of unsecured loans.
Personal line of credit
A personal line of credit is a type of unsecured credit line that can be used for whatever you want. The interest rates on personal lines of credit are usually lower than the ones you get for credit cards and personal loans.
Student line of credit
These types are really structured specifically for paying your after-high school education expenses, like tuition, housing, and books.
Other options besides a line of credit are things like personal loans and credit cards. The interest rates vary on lines of credit based on a few things, your credit score/file will be major, and the rates are usually lower than the ones you would get on loans and credit cards. For more in-depth information on this, consider our personal finance book.
Pros and Cons: Lines of Credit
Pros
Can have lower interest rates than credit cards & personal loans
Can be used for whatever you want to use it for
You only pay interest on the portion you use
Cons
Interest rates vary and your lender can change them at any time
Easy access to this money can possibly contribute to overspending - the goal is to build wealth man, be wise with your spending.
Can take a long time to pay off if you only pay the minimum payment
Line of credit vs. credit card
A line of credit and a credit card work in similar ways, but there are a few differences you should note. Before you choose one instead of the other, really think about it & understand its terms & how fits for you & your situation.
When to use a line of credit
When you need a higher credit limit to assist with investments
When you plan to take longer than a month to pay back a large balance like with a credit card
You can use a line of credit to pay for unexpected expenses like small home remodels or repairs. If you will have a shortage of funds at the end of the month and you don’t have an emergency fund to lean on, a line of credit can possibly help
When to use a credit card
If you only need access to a limited amount of money
If you can pay off your balance every month, or at least make more than the minimum payment
If you want to take advantage of any points or rewards programs
To buy cash-producing or appreciating assets
I personally use my credit card(s) for anything I would use a debit card for.
Can a line of credit affect my credit score?
Can I use a line of credit to pay off a credit card?
Do I need a certain income to qualify for a line of credit?
Can opening a line of credit affect my credit score? Yes. Opening and using a line of credit can impact your utilization rate, which will affect your credit score. Utilization is 1 of the 5 components that make up your credit score & utilization alone makes up 30% of your score. Late payments will likely also impact your credit. For more in-depth information on this consider our personal finance book.
Can I use a line of credit to pay off a credit card?
Yes, of course you can. People use this strategy to help them move their debt from a high-interest credit card to a lower-interest line of credit, so you pay less interest while you pay off the balance.
Do I need a certain minimum income to qualify for a line of credit? Usually, you will have to have a minimum household income of $35,000 to $50,000 to qualify for a line of credit.