What is a personal line of credit? How loans, interest and repayment work.

A personal line of credit is a flexible lending tool that gives you a defined credit limit that you can draw on when you need it. It’s useful when expenses are irregular or difficult to predict, such as ongoing home repairs or inconsistent self-employment income.

But this flexibility cuts both ways.

“Personal lines of credit typically carry higher interest rates than secured loans like mortgages or HELOCs,” said Craig Toberman, CFP and partner at Toberman Becker Wealth in St. Louis. “Fees often range from 10-20% APR plus potential annual fees.”

Learn more about how these types of loans work and whether an alternative might be best for you.

A personal line of credit, or PLOC, allows you to access funds up to a certain limit. Withdraw money when you need it, usually by transferring funds to your checking account through an online portal or using checks issued by the lender. You will not normally be issued a card.

Rates are usually variable. So if the prime rate moves, your monthly payment and the overall cost of your loan move with it, which is good in a falling rate environment, but costly when interest rates rise.

Fees also vary. Most lenders charge a monthly or annual fee, but some charge additional fees, such as:

Your interest rate may vary, but the initial rate you receive is ultimately up to you credit scoreincome and existing debt.

A personal line of credit usually has two distinct phases:

Draw period: You can withdraw funds freely. Minimum monthly payments are usually required. This period can last several years.
Amortization term: Withdrawals are stopped. Monthly payments increase because you are now paying back the balance plus interest in full.

Minimum payments on a personal line of credit are usually interest-only, said Melissa Cox, CFP at Future Focused Wealth in Dallas.

“This keeps your monthly bill down, but it also keeps you in debt longer,” Cox added. “I’ve seen people carry balances for years without even realizing how much it’s costing them.”

Not all lenders use the same repayment rules and terms may vary. For example, lenders may require you to pay whichever is higher: $50 or 2.5% of what you borrowed. Some lines of credit even require a lump sum payment at the end of the draw period, where you must pay back the entire balance in one lump sum.

That’s why it’s essential to understand the repayment terms before opening a personal line of credit.

Creditworthiness is the most important factor in getting approved for a personal line of credit. Lenders want proof that you are a responsible borrower who can repay them over time.

Before applying, pull your credit reports and check your credit score. A FICO score of at least 670 or higher is usually needed for a decent rate, although some lenders may expect to see a score of 760 or higher.

If your score is below 670, work to reduce existing revolving balances and clear any late payments before you apply.

In addition to your credit score and credit report, lenders also check your income, employment status, and debt/income ratio. Therefore, you will need to show that you are earning enough money to repay what you have borrowed in a timely manner.

Banks, credit unions and some online lenders offer personal lines of credit. Popular lenders include:

If your current bank or credit union doesn’t offer personal lines of credit, you’ll need to search online for one that does. You usually need to open a bank account first before applying.

The application process resembles a applying for a personal loan or credit card. You will provide personal information such as your name and date of birth, details of your existing debts, along with employment and income documentation.

Most lenders do a hard credit check when you apply for a line of credit, so be prepared for a temporary drop in your score.

Review and accept the offer

Don’t rush this final step. Read each line of the loan agreementespecially the depreciation rules. If a lender doesn’t clearly explain how your payment will change over time, that’s a red flag.

Before you sign, make sure you understand the following:

It is the interest rate fixed or variable?
How long is the draw period?
What happens when the draw period ends?
Is there an annual or inactivity fee?
How is the minimum payment calculated?
Does signing up for autopay lower my rate?

Once you accept, your line of credit is activated and you can start withdrawing funds during the draw period.

A personal line of credit can affect your credit score in several ways:

Difficult query: When you apply, there is usually a hard pull on your credit report, which can temporarily lower your credit score.
Credit Usage: If you use more than 30% of your credit line, your credit score will likely take a hit, and the closer you get to your credit limit, the bigger the drop. Use of credit It’s a big part of your credit score, so keeping your balance low is more important than the difficult inquiry that comes with opening your line of credit.
Payment history: Paying late or missing payments will lower your score quickly. Paying on time helps build credit.

When managed responsibly, a personal line of credit can help boost your credit score. But when used irresponsibly, it can just as easily hurt you.

Personal lines of credit are best for situations where expenses are unpredictable, such as:

Home repairs or maintenance
Ongoing medical expenses
Differences in short-term cash flows due to self-employment or seasonal work
Wedding planning or large event costs
Moving and relocation expenses

However, PLOCs should not be used when your budget is constantly under water. If you treat the line of credit as a bonus for spending money, you can quickly go into debt, Cox said.

“The trick is that it doesn’t feel like debt like a loan or credit card might,” Cox added. “But over time, it’s easy to slip into a cycle where you’re using it more often than you planned. . . . If you don’t have a payment plan in place, they can quickly become financial quicksand: easy to get in, hard to get out.”

Do you need to borrow money? A personal line of credit is not your only option. Here’s how other types of loans and lines of credit compare.

Credit cards work best for day-to-day spending if you can pay in full. Get a grace period to avoid interest and earn rewards. A PLOC earns interest immediately and does not offer any benefits such as cash back or miles.

Credit cards tend to have higher interest rates. PLOCs historically have lower fees, but may also charge fees. Both credit cards and personal lines of credit have limits and cost you interest when you carry a balance.

A HELOC it leverages your home equity, making it a secured line of credit. The lender has something to take if you stop paying, so interest rates are usually lower than an unsecured personal line of credit.

However, that lower cost comes with some serious strings attached. Miss enough loan payments and you could face foreclosure. A PLOC doesn’t put your home at risk, but you’ll usually pay more interest.

“A personal line of credit makes more sense if you need faster approval without appraisal requirements, want to avoid putting your home at risk, or need a smaller line of credit that doesn’t justify the closing costs of a HELOC,” Toberman said.

both of them personal loans and personal lines of credit allow you to borrow without collateral. The difference is how you access the money.

A personal loan gives you a lump sum upfront. If you’re approved for $25,000, that amount is sent to your bank account and paid back in set monthly installments. It’s predictable and works well for one-off costs, but you’ll be paying interest on the full amount right from the start.

A personal line of credit acts more like a credit card. Only take what you need and you can borrow again as you pay, up to your limit.

Personal loans usually have fixed APRs, which helps make payments predictable. PLOCs typically use variable APRs tied to the prime rate, so they can start out competitively, but move with the market.

If you want payment stability, personal loans are probably the way to go. If you will be borrowing for a short time and rates are stable or falling, a PLOC may be cheaper.

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