Line of Credit

Keep in mind, the advice below is a generalization in regards to various types of Lines of Credit. Whenever one gives advice about lines of credit, they are forced to generalize and try to cover as many bases as possible. What I have below is no exception. Although I attempt to cover the "rules" of as many types of lines of credit as possible, it is always wisest to read all of the fine print and information about a line of credit account before using it.

What exactly is a Line of Credit?

The two most common types of Lines of Credit (LOC) would be a personal LOC (PLOC) and a Home Equity LOC (HELOC).

All lines of credit follow these rules:

1. They are a revolving loan.

2. They have a set borrowing limit ("credit limit").

3. They require a minimum monthly payment (usually 2% to 3% on a personal LOC and 1% to 2% on a HELOC).

4. Unlike an installment loan, you are unable to pay the loan in advance.

5. You only have to pay interest on the outstanding (borrowed) balance.

A LOC is a loan that you can receive that will, in essense, assure a certain amount of funds are available whenever you need it. Furthermore, you only pay interest on the money you have borrowed.

For example, say you are approved for a $5,000 line of credit at 10% interest. Assuming there are no annual fees, you can have this LOC for 5 years and never pay one cent in interest if you never borrow any funds. Let's say after 5 years you need to borrow $1,000 from the LOC.

For the sake of argument, let's say that you borrow the $1,000 on January 1. Now if you turn around and pay all $1,000 off (for whatever reason) the very next day, you will only owe one day's worth of interest. The daily interest (or "per diem") would be approximately 27 cents ([$1,000 X .10] / 365). So on January 2nd, the payoff balance would be $1,000.27. Each day that passes after January 2nd, another 27 cents is owed onto the account. The only exception would be when/if payments are received on a regular basis (rather than a complete payoff). Payments would decrease the per diem according to the remaining loan balance.

So, continuing the example, you will notice that on January 3rd, the payoff would be $1,000.55 (because of rounding upwards); $1,000.82 on January 4th, etc.

Going back to the beginning of the example, let's say that you borrow $1,000 on January 1 and intend to pay it off in 6 months. Now, the institution you borrowed the $1,000 from will require a minimum monthly payment (usually 2 to 3%). Let's use 3% for our example. And, for the sake of simplicity, let's assume that the statement ending date on the LOC is the last day of each month and that the due date for the minimum payment is due the last day of the following month. This means that on January 31st our statement will cut and we will receive in the mail a few days later our loan statement and due date. The statement will then inform us that the minimum payment of $30 ($1,000 X .03) is due February 28th. Unlike a credit card, however, this is not "free money" (due to the grace period on credit cards) until February 28th: you will be paying interest on it the whole time. As I mentioned before: if you borrow the money on Jan 1 and pay it off on Jan 2, you will still owe 27 cents in interest. If this were purchases made on a credit card, you'd have a grace period (usually 25 days) where you could pay it off and still not owe interest. So in this case, you could charge on the credit card and not have any interest due as long as you pay the balance off in full by the due date.

So, let's say you send in your payment on February 15th (cause you always want it to be early rather than late, right?) and the institution receives and posts the payment to your account on February 19th. This would mean that 50 days would have passed since the day you borrowed the money and the day you made your minimum payment.

If you remember, our per diem (how much it costs you to per day to borrow these funds) is approximately 27 cents. So, when you send in your minimum payment of $30, the first $13.70 ([$1,000 X .1] / 365 X 50) goes directly to the financial institution as an interest payment. This means, instead of owing $970 on February 19th, you still would owe $983.70. Our per diem is still actually at 27 cents (due to rounding) but as you make more and more payments your per diem will approach 0.

The rules for lines of credit are very similar to the rules for credit cards. In the case of LOCs, however, it is important to realize that there are never (or at least should be never) any transaction fees like there might be for credit cards. Credit cards were created to primarily be used for purchasing goods or services and not as a means in which to have quick access to cash. Lines of credit can be used to purchase goods or services, but this should not be their primary use.

Furthermore, a credit card most likely will charge you a fee if you use it to access cash instead of use it for purchases. This is known as taking a cash advance on the credit card. Cash can be accessed from a credit card in a number of ways: withdrawal at an ATM machine, doing an actual "cash advance" inside a financial institution, or even going online or making a phone call and transfering the balance directly to a savings or checking account (assuming the accounts are somehow linked).

When it comes to lines of credit, however, the only fee you should EVER see would be an annual fee. And, even then, I would strongly suggest to hunt for another line of credit if the one you currently have (or are looking to get) charges an annual fee. There are plenty of financial institutions who can supply you with a fee-free personal line of credit; and even home equity lines of credit can be found fee-free if you look hard enough.

Only spend what you need

Lines of credit, like most loans, can be very alluring - it's literally access to cash that can give you the opportunity to buy anything within the limits of the credit limit. But, like all loans, you must be very careful not to stretch yourself too thin financially. It is especially important if the line of credit you have requires interest only payments. This is most common with home equity lines of credit. With this you do not receive a true idea of how much money your spending is costing you. Just like making the minimum payments on credit cards, you can easily fall into a viscious cycle of spending too much and thinking that it's "ok" since your monthly payment will only be $25, $50, $100, etc. Read about interest only loans in the glossary to get an idea of how dangerous they can be.

Always pay it off

Since lines of credit have no grace period like credit cards, you will have to pay interest on the money you borrow the day you borrow it. For this reason, you should never hold a balance in a savings/checking account and a LOC at the same time for more than a few days or weeks. There is absolutely no reason to pay the minimum payment due on a LOC while there is enough in a liquid savings/checking account.

If you don't quite understand why, think of it this way. When you put your money in a savings account, the financial institution will (hopefully) pay you an interest rate - let's say at 3% just for example. Let's say you have $2,000 in the savings account. At 3% APR you will receive $60 per year, or $5 per month. (I'll keep it simple and ignore compounding interest for this short-term example). Now let's just say you happen to have a line of credit balance of $2,000 at 10% interest. Assuming you spend no more money (and save no more money) you will end up paying $200/yr or $16.67/month. See the problem? You have a net balance of zero (you have $2,000 but also owe $2,000) but your paying $16.67 per month and only receiving $5 per month back in interest. In other words, you are LOSING $11.67 per month just for the "privelige" of having a line of credit balance.

questions - comments - concerns? Email me at bdehler2004@yahoo.com


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