If you need to borrow money, you probably already know you can use a credit card or request a personal loan. But you also have a third option—taking out a line of credit.
A line of credit (LOC) is a preapproved pool of money offered by a bank or other lender that you can borrow against as needed.
Here’s a quick overview of what you should know before opening one, and the steps involved in getting a line of credit open in your name.
What to know before taking out a line of credit
Before you take out a line of credit, it’s important to make sure you understand how they work and the risks that might be involved. Some considerations include:
Lines of credit have draw periods
Like a credit card, a line of credit (LOC) has an upper limit to how much you can borrow, and you’ll owe interest on whatever you borrow. Unlike a credit card, most lines of credit have a draw period during which you can access funds from your LOC and typically make interest-only payments.
Once the draw period is over, you’ll need to repay what you’ve borrowed—either in a lump sum or in monthly payments, based on your agreement.
If you reach your borrowing limit before your draw period is over, you can pay down your balance to continue using the line of credit.
Some types of LOCs will require collateral
Collateral is property or assets that can be forfeited to a lender if you default on a loan. If you're unable to pay back what you borrow, they may seize the property or assets to recoup their losses.
In most cases, you become a less-risky borrower to your lender when you put up some form of collateral. A secured LOC, meaning an LOC that is “secured” with some kind of collateral, will often have higher borrowing limits and lower interest rates than an unsecured LOC that doesn’t have any backing collateral. The key risk for you, however, is that you may lose whatever collateral you have put up against the line of credit.
There are different types of LOCs
These are the primary types of lines of credit you may encounter, each of which may handle collateral a little differently:
- Personal lines of credit are unsecured, which may result in lower borrowing limits and higher interest rates compared to a secured line of credit.
- Home equity lines of credit (HELOCs) are secured by however much equity you own in your home, which acts as collateral.
- Securities-backed lines of credit (SBLOCs) use your investment portfolio up as collateral. How much you can borrow will be mostly determined by the size of your portfolio.
- Business lines of credit are specifically available to business owners and can only be used for business purposes. These LOCs may be secured or unsecured, depending on the size of the line of credit and other factors, such as the business’s valuation and revenue.
Interest rates for LOCs are usually variable
When you borrow against a line of credit, you need to repay what you borrow and make interest payments on the balance, as you would with any other loan. While some lenders may offer lines of credit with fixed interest rates, they will often carry variable rates, which can rise or fall depending on a variety of factors, including changes to rates set by the Federal Reserve.
Variable interest rates can be risky because they mean your monthly payments could fluctuate over time. This may result in lower payments if interest rates fall, but you should be prepared to make higher payments if rates go up.
LOCs may be accessed a few different ways
Your issuer may provide checks you can write to access your line of credit, offer the option to have money deposited into your bank account at your request, or automatically draw on your credit line to cover overdrafts on your checking account.
How to get a line of credit
Here are some common steps to get a personal line of credit or a HELOC.
1. Check your credit score and take steps to improve it if necessary
When you apply for a credit line, a lender will check your credit score to determine your risk as a borrower—just like when you apply for any other type of loan. They’ll then use that score to decide whether to approve you for the LOC, and to determine your interest rate.
While all lenders are free to determine their own credit score requirements, many lenders require a minimum credit score of at least 680 for a personal line of credit or 620 for a HELOC. Generally speaking, the higher your score is, the more likely you’ll be approved for the credit line and the more favorable your interest rate may be.
It’s a good idea to check your credit score before beginning the application process, so you’ll have realistic expectations for your chances of getting approved. This will also give you the opportunity to take steps to improve your credit score, such as paying down the balances on other debts you may have or disputing the details of your credit report.
2. Decide if you want to put up collateral
Do you have access to assets that you can put up as collateral for your line of credit? Do you want to put those assets up as collateral?
While doing so can result in higher borrowing limits and lower interest rates compared to an unsecured personal line of credit, it’s important to remember the risks: In other words, you risk losing your collateral if you’re unable to make your monthly payments once the draw period ends.
3. Shop around for a lender
Once you decide what you’re willing to put up for collateral, you can choose a type of line of credit to apply for and begin searching for lenders (including banks and credit unions) that offer that type of LOC.
The terms offered by lenders can vary significantly, so it’s important to shop around to make sure you’re getting the best deal. Consider factors like the lenders’ credit score requirements, borrowing limits, origination fees, closing costs, and interest rates.
4. Submit an application
After choosing a lender, you’ll need to complete and submit an official application–either online, in person, or using hardcopy forms, depending on the lender. Like other loan applications, this process typically involves a credit check and requires documentation such as bank statements and W-2s, to prove your employment and source of income.
If you’re applying for a HELOC, the lender will also assess your home’s value and equity you have, which may involve an appraisal. Please note HELOCs typically take longer to get access to funds, relative to a SBLOC.
This information helps determine your borrowing limit.
How to get a securities-backed line of credit
The process for getting a securities-backed line of credit is like the process above, with a few key differences.
1. Make sure you meet your brokerage firm’s asset requirements
Check your portfolio to determine whether you have enough assets to apply for a securities-backed line of credit with a brokerage firm. The minimum asset requirement varies from firm to firm; at Fidelity, for example, investors must have at least $500,000 of nonretirement assets to qualify for an SBLOC. Eligible assets include stocks, bonds, mutual funds, ETFs, and portfolio cash not held in a retirement account.
Keep in mind that your brokerage firm may disable features of your account, such as withdrawing from accounts being used as collateral. Also, because the loan is secured by collateral, if the value of your collateral changes, you may be required to provide additional funds or assets as collateral or repay part of the loan.
2. Contact a representative of the firm
Once you’re sure you meet your firm’s asset requirements, kick off the process by contacting a representative who will review your eligibility, explain the application process and how the SBLOC works, and answer any questions you may have.
Some questions you might want to ask include:
- What are the borrowing limits?
- Who is the actual lender—the firm or an affiliate bank?
- Who do you contact for questions or loan servicing?
- What happens if the value of your portfolio decreases while you have an SBLOC against it?
- What interest rates are available?
- What fees might you owe?
3. Complete the application
Finally, you’ll need to fill out an application, which may require sharing details about the size and makeup of your investment portfolio. This step is typically facilitated by your brokerage firm.
What to do after you take out a line of credit
Once you’ve been approved for a line of credit, here are a few tips to get the most out of it without compromising your overall financial health.
Know how long your draw period is
Most lines of credit will have what is known as a draw period. This is the amount of time you can actively borrow against your credit limit. Once the draw period is over, you’ll be required to begin making principal payments toward your original loan as well as the interest on it until you’ve paid back your balance. Knowing the length of the draw period can help you prepare your budget as you approach the payback window and make a plan for when you want to draw on your line of credit. After all, just because you've opened the line of credit doesn't mean you need to use it immediately.
Begin making interest-only payments
In most cases, you won't be required to make principal payments during your draw period, but you will be required to make interest-only payments based on what you’ve borrowed. Take note of your payment due date and set a reminder in your calendar so you don’t accidentally miss a payment, which could damage your credit score and potentially lead to late fees. If your lender offers it, you might opt into autopay.
Consider making early principal payments
If you want to reduce the amount of interest you’re paying each month or want to get a head start paying down your balance, you can always make early principal payments even when they’re not required. Depending on your interest rate and principal, these payments can save you hundreds or thousands of dollars in interest over the course of repayment.
The bottom line
Before you open a line of credit, it's important to understand your options and have a plan for repaying your loan that you can commit to in the long term. Be careful not to overextend your finances.