A line of credit is an amount of money to which you have access up to a specific limit over a period of time. A fee is usually charged for establishing the line of credit. However, interest is only charged on the amount of the outstanding balance.
The line of credit may require regular monthly repayments or allow full flexibility in repaying, provided that it is fully repaid at the end of the agreed period. The fees, interest rate and other terms will tend to vary according to the reputation, credit rating, income prospects and financial obligations of the applicant.
An example is a line of credit of $10 000 at 14 per cent interest for a five-year period negotiated by Ronald with his bank. Ronald is a writer and a freelance instructor. Some months, he may earn as much as $6 000 from his teaching assignments. Then other months he is lucky if he raises $1 000 from the articles he writes for a local magazine.
This line of credit allows Ronald the flexibility of meeting his monthly expenses along with unpredictable repairs to his home or car despite the variability in his income during the period. In addition, besides paying the upfront fee for setting up the line of credit, interest is only due on the outstanding balance. The outstanding balance should not exceed the $10 000 limit and if it is zero, when the line of credit is not used at all, no interest is due.
Furthermore, Ronald has a specific plan to repay the line of credit fully by or before the end of the five-year period. This plan involves establishing a personal emergency fund to replace the role of the line of credit during the life of the line of credit. Smart use of a line of credit also improves Ronald’s credit rating and relationship with his bank.
A line of credit is not an inherently good or bad debt vehicle. It depends on how effectively it is used. In Ronald’s case, he would have drawn on this facility effectively in stabilising his variable earning pattern over time.
Originally, lines of credit were targeted mainly at businesses as a source of working capital financing given the variability that can occur with stock, sales and collection of accounts receivable. In more recent years, financial institutions have been marketing this service to individuals.
People like consultants, professionals and sole proprietors who have widely variable income streams can make good use of such facilities. Lines of credit are typically cheaper and more flexible than using credit cards. There is great flexibility in what the line of credit can finance. Where a mortgage loan is for real property and a vehicle loan is for the purchase of a vehicle, the available balance on a line of credit can finance whatever the holder fancies, provided that the credit limit is observed.
On the other hand, a line of credit is not recommended for financing a one-time purchase like a house or a car. Better credit deals are usually available for such specific purchases.
Your credit card, gas credit card and store credit card serve in a way like a pre-approved line of credit. So, you have had some experience. With a line of credit from a financial institution, just ensure you are clear on the fees, the interest rate, the repayment schedule and penalties for exceeding the limit. Now you understand how they work, it should be as simple as your store credit card once used in the right context.
• Louise Fairsave is a personal financial management adviser, providing practical advice on money and estate matters. Her advice is general in nature; readers should seek advice about their specific circumstances. This column is sponsored by the Barbados Workers’ Union Co-op Credit Union Ltd.
