In this age, credit has become a vital part of modern financial life for both companies and individuals. Financial services providers (known as lenders) provide credit to borrowers in exchange for a number of additional charges, interest and arrangement fees among them. Of course, credit is quite a sensitive topic to approach at the moment, given that the ongoing economic downturn was partially brought about by the (too) widespread availability of credit, a factor which has prompted analysts to dub the current financial crisis “the credit crisis”. Not only has the credit crisis altered the overall perception on consumer and business credit, but it has also impacted the circumstances under which lenders agree to extend lines of credit to borrowers.
In simple terms, a line of credit (also known as a credit line) is a type of credit granted to an institutional or individual borrower by a financial services company (for example, a bank). The bank (also known as the lender or creditor) provides the resources needed by the borrower (also referred to as debtor). The latter does not reimburse the immediately, but repays the debt either at a later date in full or in installments over a pre-arranged interval, as per previous agreement. A line of credit essentially takes the form of an account through which a certain amount of money is made available to the borrower. The lender and borrower agree on a maximum loan balance that the former will permit the latter to maintain. The borrower can thus access the funds should the need arise, mostly by withdrawing cash upfront rather than using the account to pay expenses, like in the case of a business credit card. The borrower may make multiple withdrawals from the approved credit line, as long as the maximum loan balance stipulated in the agreement is not exceeded.
Credit lines
A line of credit has a number of things in common with a credit card – they essentially function based on the same principle (they are both unsecured, revolving credit instruments), but were designed to address the needs of different categories of consumers. Thus, the lines of credit principally target businesses, and their main purpose is to assist the organizations in covering impending liquidity problems by offering them direct access to cash. Credit cards mainly target consumers and they are mainly used for routine, daily purchases, with a number of limits imposed on cash advances, which are perceived by banks as more risky than actual credit card purchases. Unlike a credit card, a line of credit does not have a grace period in which no interest is charged for the amount withdrawn. On the other hand, for a credit line, interest is only charged for the portion of the credit which is effectively withdrawn and used, while the unused portion is interest-free.
For a business, a credit line may take several forms – a cash credit, a demand loan or a term loan. While generally the credit cards are perceived as being better for consumers and the lines of credit as being better for businesses, an individual can take out a personal line of credit, if he or she has built a good credit score and has a solid credit history. A personal credit line can be a very useful financial tool, provided that it is used with care and restraint. A personal credit line can be a good borrowing alternative to a credit card, mainly due to the fact that interest is only charged for the part of the line of credit that is actually used. Individual borrowers who are approved for a personal line of credit can resort to it whenever they need cash, as long as the amounts withdrawn do not exceed the maximum loan balance. However, like a credit card, a line of credit makes money easily available to consumers, prompting excesses. Therefore, consumers who are looking to tap a personal line of credit should exercise a great deal of caution over their expenses and keep a close eye on their spending habits.
When it comes to discussing about personal credit lines, a special attention must be paid to a particular variety of credit line, – the so-called home equity line of credit, also dubbed HELOC. The term was featured frequently in reports dealing with the causes of the current subprime mortgage crisis. But what is a home equity line of credit, you will ask? HELOC is in fact a loan agreement in which a bank agrees to provide the borrower with a maximum amount of money within a pre-defined interval (a term). The borrower’s equity in their own house is used as collateral. When a home equity loan is granted, the lender does not provide the borrower with access to the entire loan amount up front; rather, the lender grants the borrower a line of credit from which the borrower takes out amounts that total no more than the maximum credit limit.
Credit lines
Thus, the borrower can access the home equity line of credit funds during a draw period which varies between 5 and 25 years (typically, although terms may vary). The borrower pays back the amounts drawn, to which an interest rate is applied. Depending on the terms of the loan, minimum monthly payments may be required, however as a general rule, the borrower can repay any amount he or she chooses to, as long as it exceeds the value of the minimum payment and as long as it doesn’t exceed the total outstanding. The full main amount is usually due at the end of the draw period (in the form of a lump sum payment), but other arrangements can be made; for example, the borrower and the lender can agree on a loan amortization schedule.
The interest rate on a home equity line of credit is not fixed (unlike in the case of a loan), but can vary in time depending on various factors, such as the prime rate. This level of flexibility (particularly the flexible repayment part) was one of the reasons which caused home equity line of credit loans to become highly popular among Americans over the past decade. However, individuals tended to overlook one basic fact: the underlying collateral for any home equity line of credit is of course the borrower’s home. In other words, if the debtor fails to repay the loan or disregards loan requirements, he or she may effectively lose his home. The bubble burst in 2008, when a series of important players on the home equity market (Bank of America, JP Morgan Chase, Washington Mutual, Citi and Wells Fargo among them) started to freeze, reduce, suspend, rescind or else impose some form of restriction on borrowers’ home equity lines of credit due to falling house prices.
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