Line of Credit
Line of Credit
What It Means
A line of credit (often referred to as an LOC) is a form of loan in which a bank or other financial institution (the lender) grants an individual (the borrower) the right to spend up to a certain preset amount of money (called a credit limit). Unlike an installment loan, where the borrower takes out the entire loan amount up front, a line of credit means that those funds are available to the borrower but that she is only accountable for the amount that she uses. For example, if Gwen takes out a $3,000 line of credit but ends up spending just $1,750, then she only needs to make payments and pay interest (a fee that is charged for borrowing money) on the $1,750, and the additional $1,250 remains available for her to use if she needs it in the future. Both kinds of loan charge interest, a fee that is calculated as a percentage of the amount of borrowed money.
Because it continues to turn over (or renew itself) from one billing cycle to the next, a line of credit is defined as “revolving credit.” Whereas an installment loan (such as a home loan or a car loan) is paid off in a set number of equal installments, the amount a person owes on a line of credit continually fluctuates depending on the amount he spends versus the size of the payments he makes. Meanwhile, as he pays his balance down, the size of his required monthly payment also decreases. The balance that remains on the account from one month to the next is called revolving debt.
A line of credit offers more flexibility than a traditional installment loan, but it also carries some risk. An installment loan has an interest rate (the percentage used to calculate the interest fee) that is locked in, meaning it will not change over the lifetime of the loan. In contrast, the interest rate on a line of credit is variable, meaning that it will fluctuate according to changes in the economy. This can be advantageous for the borrower if interest rates are falling, but disadvantageous if they are rising.
When Did It Begin
Instances of people taking on obligations of debt can be traced to ancient civilizations, but consumer credit did not become a fact of life until the mid-twentieth century. In the nineteenth century many merchants allowed some customers to pay for furniture and other household goods on installment plans. Still, however, then and in the early twentieth century, it was almost unheard of for a financial institution (such as a bank) to extend consumer credit. This was in part because of the difficulty of assessing the average individual borrower’s financial dependability, and also because managing such loans required too much money and effort.
The advent of consumer credit as we know it today coincided with the mass production of consumer goods and the increasing urbanization of American society, trends that became particularly strong in the era after World War II (which ended in 1945). The initial rise in consumers’ use of credit after the war was related to people taking out loans to buy homes, but after credit cards were introduced in the 1960s, the number of American families carrying revolving debt increased steadily. Whereas in 1970 only 16 percent of American families held a general-purpose, bank-issued credit card, by 2006 that number had risen to 71 percent.
More Detailed Information
A line of credit may be secured or unsecured. A secured line of credit is one in which the borrower puts up some form of collateral (property of value that will be forfeited to the lender if the loan cannot be repaid), such as a building, car, or business. Although the borrower risks losing his property when he takes out a secured line of credit, the benefit is that he can usually obtain a significantly higher credit line at significantly lower interest than with an unsecured line of credit. This is because the lender’s risk of losing money is greatly reduced by the collateral. A secured line of credit can be a useful financial tool, especially for small business owners who may need extra funds to buy new equipment, cover payroll, launch new marketing initiatives, or simply maintain steady cash flow (the balance between incoming and outgoing money) through ups and downs in sales.
A home equity line of credit is also secured, with the collateral being the house the borrower owns. With this line of credit, the limit is determined by the amount of equity the person has in his or her home. Equity is the difference between the market value of the home (how much it could be sold for) and the outstanding balance (amount still owed) on the original home loan. Many people take out a home equity line of credit in order to finance home repairs, improvements, and remodeling. Still, however, there are no restrictions on what this line of credit can be used for, and many people also use it to pay for college tuition, medical expenses, or even a vacation splurge. Another significant advantage of a business or home equity line of credit is that the interest the borrower pays on the debt is often tax deductible. That is, when it comes time to pay annual income tax, he can subtract the interest payments from his earnings, thereby reducing the amount of income tax he has to pay.
An unsecured line of credit is one in which the lender extends credit without the borrower putting up any collateral. A credit card (an electronic-payment card) is an example of an unsecured line of credit. In the absence of collateral, the lender must judge how reliable the borrower is (and therefore how much credit to extend and how much interest to charge) based solely on his or her proof of income and credit score (a kind of financial report card that details a person’s payment history with creditors, landlords, utility companies, and others). Because the borrower does not put his or her property directly at risk—indeed, the borrower does not even need to own any property—he or she can expect the lender to offer a more conservative amount of credit and charge a higher interest rate.
Banks that issue credit cards have been in the business of extending unsecured lines of credit to consumers since the 1960s. These cards may be used to make purchases anywhere that the particular card brand (such as Visa and MasterCard) is accepted. Individual retail chains (including Target, Home Depot, Best Buy, Macy’s, and Sears) also extend their own unsecured credit lines to customers for exclusive use in their stores. In the 1990s many retailers, realizing that there were profits to be made from offering credit cards, began to promote such cards more aggressively.
Here is how it works: Alfred goes to the checkout at Target, ready to pay for his purchases with a Visa card, or perhaps with cash. The cashier tells him that he can get a 15 percent discount on these purchases if he applies for a Target Card (line of credit). The application process is simple; he can be approved for at least a small line of credit on the spot, and as long as he opts to pay for the purchases with his new Target Card, he can save 15 percent. The problem with these exclusive merchant lines of credit is that they often carry much higher interest rates than regular credit cards. Therefore, if Alfred carries a balance on this card, the interest charges will quickly make him lose his 15 percent savings.