A line of credit is a type of loan wherein a bank or other lender makes a certain amount of money available to a certain borrower for a particular period of time, called a term. This borrower can be an individual, such as with a home equity line of credit (HELOC), or a business. Unlike a standard loan, a line of credit allows you to borrow only the money you need at a given time, as opposed to a lump sum. While this makes a line of credit a more flexible means of borrowing, there are also several disadvantages you should consider.
While many other types of loans have fixed interest rates, meaning you know precisely what percentage of your borrowed cash you will need to pay back at a given time, a line of credit has a variable interest rate. According to mortgageqna.com, this means that every month there is a chance that your interest rate could increase.
Reducing the Principal
Another issue with line of credit interest rates is that they do not necessarily ensure that you are paying back the principal, or main balance of the loan. The payments you make each month may only be covering the interest that has accumulated, so once the term of your line of credit ends, you may still have to pay the lump sum of what you have borrowed, called a balloon payment. According to federalreserve.gov, there are some lines of credit plans wherein all of your regular payments go towards paying off interest, and a balloon payment is expected at the end of the term.
With a home equity line of credit, your home serves as collateral. According to federalreserve.gov, if you are unable to repay the amount of money borrowed (and any leftover interest), the bank or lender can legally take your home in compensation. However, typically--and especially in the case of balloon payments--you may be able to avoid this by taking out another loan to cover outstanding costs. According to the Minority Business Development Agency at mdba.gov, in the case of business lines of credit, collateral is not needed unless the borrower does not meet specified credit history criteria.
In general, to obtain a HELOC you will need to pay an application fee and some upfront charges (which are usually a percentage of your credit limit), and you will have to pay to have your home appraised, according to federalreserve.gov. During your term, you will also be subject to transaction, maintenance and/or membership fees. Once your term ends, you will have to cover closing costs, such as attorney fees and taxes (if any), for example. In comparison to other loans, a line of credit has expensive application fees, and also comes with annual service and/or maintenance fees, according to banklady.com. These fees are added on top of your standard monthly payments.
Lauren Treadwell studied finance at Western Governors University and is an associate of the National Association of Personal Financial Advisors. Treadwell provides content to a number of prominent organizations, including Wise Bread, FindLaw and Discover Financial. As a high school student, she offered financial literacy lessons to fellow students.