Personal lines of credit are becoming more common for bridging short-term gaps in cash flow. Compare them first with other forms of credit.
Your best client owes you $25,000 — you know they’ll pay, but in the meantime, bills are due. You work on commission and your income, while excellent annually, is a roller coaster month to month. Bottom line: Your financial boat is temporarily swamped.
A personal line of credit may be able to bail you out, but it’s important to understand how it compares to other credit options.
A personal line of credit is an unsecured revolving account with a variable interest rate allowing you to borrow money as you need it, says Natalie M. Brown, vice president of consumer lending communications for Wells Fargo. A personal line of credit may be cheaper than a credit card cash advance, more flexible than a personal loan and won’t require collateral as does a home equity line of credit. But it’s not for everyone.
How it works
The maximum amount you can borrow varies widely based on your financial institution and credit qualifications. Citi’s top credit limit is $25,000, while SunTrust allows lines of up to $250,000. At Wells Fargo, the range is $3,000 to $100,000, Brown says.
You won’t necessarily have to say what you want the money for when you apply, but you could. It will depend on the lender and the amount being borrowed, says Nessa Feddis, senior vice president and deputy chief counsel for the American Bankers Association.
You can access your personal line of credit by check, phone or online, Brown says, adding that your monthly payments depend on how much you owe. For example, the minimum payment at Wells Fargo is $25 or 1 percent of the balance owed, plus the total of all finance charges and fees. The bank charges a $25 annual fee, Brown says, an amount that CreditCards.com found to be typical.
Who qualifies for a line of credit?
Because personal lines of credit are not secured with collateral, they are generally offered to customers with a strong credit history who not only have a strong credit score but also can demonstrate an ability to repay the line, Brown says.
The better your credit rating, the more likely you are to get a personal line of credit on good terms, says Mike Sullivan, director of education for Take Charge America, a nonprofit credit counseling agency based in Phoenix. Every institution sets rules and standards and those standards change rapidly based on competition and other factors, he says. “I would guess that someone with a 650 FICO could find a willing lender, but I have no real knowledge of actual terms at multiple institutions,” Sullivan says.
People who take out personal lines of credit usually are not in a situation with no other options. They often have assets such as certificates of deposit, bonds or stock accounts, or a retirement fund but don’t want to cash out those assets, Sullivan says. For example, if you borrow from a retirement account and can’t or don’t repay it, you’ll have to take a penalty and pay interest, he says. “Those options may cost you a lot more,” he says.
Why you might need one
For people who work on commission or otherwise have irregular income, a personal line of credit can smooth out finances, Sullivan says. “If you have uneven cash flow, occasionally you may have a cash flow issue,” he says. “A personal line of credit is something that a person can access on a regular or irregular basis to get from a bad month to a good month.”
Sullivan once suggested a personal line of credit to a client who needed to close on the purchase of a vacation home a month before he could finalize the sale of another house. “He was concerned about having to withdraw $15,000 from a retirement fund to do that,” Sullivan says. “I suggested a personal line of credit to him as a one-time option and it worked very well.”
Another reason credit counselors might recommend a personal line of credit is to pay a tax bill, says Sheri L. Stuart, senior communications specialist for Springboard Nonprofit Consumer Credit Management, in Riverside, California.
When to back off
Student loans are a different story. Because of tight federal regulations on education loans, you’d likely have trouble being approved if you tell the lending officer you want to use a personal line of credit to pay for college, Feddis says. The Federal Reserve Board’s amendments to the Higher Education Opportunity Act stipulate that creditors that extend private education loans must provide disclosures about loan terms and about federal student loan programs that may offer less costly alternatives. As a result, banks are wary about offering lines of credit for such purposes.
In addition, a personal line of credit is not intended to allow you to buy things you can’t afford, Sullivan says. “If your problem is an imbalanced budget, a personal line of credit is not the answer.”
If you lack financial willpower, a personal line of credit is a bad idea, Stuart adds. “You have pretty quick access,” she warns.
Comparing borrowing costs
Before you decide to take out a line of credit, compare the costs to other types of credit that may be available to you. Look at the annual percentage rate (APR), whether and how much the APR can change, any fees to access the line, annual fees, late payment fees and fees for other issues, Sullivan says.
Interest rates vary widely even from the same financial institution. For instance, Citi’s advertised rates range from 7.74 to 21.99 percent APR. Citi and other financial institutions offer interest rate reductions for borrowers willing to have payments deducted automatically from their bank accounts. At Citi, the reduction is 2.5 percentage points.
Wells Fargo, which is promoting personal lines of credit through September 2014, is offering rates as low as 7 percent, with a one percentage point reduction for qualifying customers with a Wells Fargo checking account.
Line of credit versus a personal loan
A personal line of credit allows you to borrow only the money you need and offers a variable interest rate that is generally lower than fixed loan rates, Brown says. Your payments are variable depending on the outstanding balance, she says.
In contrast, a personal loan is best suited for paying off a high-interest debt that carries a fixed interest rate and fixed monthly payment, Brown says. You receive the entire loan amount up front and it provides easy budgeting that can help you pay down high-interest debt at the end of the term, she says. “Wells Fargo personal loans offer fixed interest rates over a fixed term, which allows a customer to know precisely when their loan will be paid off,” Brown notes.
Although some people use a personal line of credit as a consolidation loan to pay off credit card debts, Brown and Sullivan recommend against it.
“It’s possible mathematically to save money, but that’s highly unusual,” Sullivan says. “If you have already maxed out all your credit cards and you’re thinking ‘Where can I go to get more money?’ a personal line of credit is a bad idea. A person who has debt issues is unlikely to qualify for a personal signature loan or line of credit but even if they qualify, they are going deeper into debt. This is much like taking out payday loans because there are no other options. It represents uncontrolled borrowing and is a sign of impending default.”
If you’re not disciplined enough to avoid borrowing more than you can reasonably pay back, skip the line of credit, Stuart says.
Line of credit versus a credit card cash advance
Credit card cash advances are similar to personal lines of credit in that you get only the money you need when you need it. But credit card APRs tend to be higher than those of lines of credit. “In my experience, credit cards run at least 13 percent APR even for consumers with good credit,” Sullivan says. “A personal line of credit is typically less and often under 10 percent for someone with good credit.”
But that’s not always the case, so be sure to check. Credit card cash advances also come with higher APRs than a card’s purchase APR as well as extra fees, which you’ll need to compare with the fees on the line of credit you’re considering.
Personal line of credit versus HELOC
If you own a house, a home equity line of credit is another option you might want to consider instead of a personal line of credit. The interest rate on a HELOC generally will be lower because the home is used as collateral, Brown says.
However, whenever you use collateral you are putting that collateral at risk. If you can’t repay the HELOC you can lose the house. A personal line of credit is not secured, so it is a safer loan for the consumer, Sullivan says.
A HELOC may also not be right for you if you’re upside on your mortgage and thus have no equity. In that case, you likely won’t qualify for a HELOC, Brown says.
Experts differ on whether a personal line of credit is a good idea in that situation. “I don’t think you’d be a good candidate for a personal line of credit if you’re already upside down on your home,” Stuart says. “A personal line of credit is not secured. You already look like a financial challenge [to a lender].”
Not so, argues Feddis. A lack of home equity doesn’t show up in your credit report, she says. “Just because the value of someone’s home declined in a huge real estate bust, that’s not predictive of whether they can pay a loan back. If you have a strong credit history, that’s heavily weighted when you’re seeking a loan.”
Impact on your credit score
One final point to consider when weighing a line of credit is the impact it will have on your credit score. In credit scoring, a personal line of credit is treated as an open line of credit, says Maxine Sweet, president of public education for the credit reporting company Experian.
“If they haven’t used it, it should help their credit utilization and thus their score,” Sweet says. “If they have used a high percentage of the line of credit, it could negatively impact their scores due to high utilization.”
See related: Landing and maintaining an unsecured line of credit for your business, Using personal loans to pay off credit card debt, Compare 8 home improvement financing choices