How lines of credit affect credit score
Before there were faster, more efficient ways of processing payments with your credit card, you would be able to take out what's called a line of credit. These are still available today, but are not as common. Taking out a line of credit is similar to a loan or using your credit card, but with some differences, which we will explore in more detail in this article.
Like credit cards, a line of credit is considered revolving debt and treated similarly when generating your credit score—if you make your payments in full and on time, it will reflect positively in your credit score.
In this article, you will learn:
- How lines of credit work
- If lines of credit affect your credit score
- Why a line of credit may not be a suitable option
How do lines of credit work?
To help you understand how lines of credit work, it may be helpful to unpack the concept of revolving credit. Revolving credit essentially means that you've made an agreement to be able to borrow money repeatedly up to a set limit while repaying a portion of the current balance due in regular payments. With every payment you make, (aside from interest and fees), you're replenishing the credit available.
If you've ever opened up and used a credit card, you'll likely know that you generally use the money available to you as you need up to a maximum amount. For example, you may have a credit limit of up to $6,000 on one of your credit cards. This type of "loan" allows you to use money from your credit as needed and pay it back (plus any interest you may accrue if you can't pay off the balance) over a prescribed period of time.
Lines of credit work similarly to revolving credit in that you can take out a certain amount of money to be used for a wide range of reasons (such as covering large expenses or refinancing your home). Let's dive into the key differences between these types of credit below.
Lines of credit only last for a specific period (for example, about 3-5 years). During that time you have access to those funds, but can no longer access them after that time frame is over. However, you will still be expected to make payments on any outstanding balances even after this time frame.
Credit cards have a set credit limit, but there is an expectation that you will pay at least the minimum payment due at the end of the billing cycle. With credit cards, there's a specific payment cycle—with a line of credit, the money is available upfront for you to use during a set time period (or draw period). These funds are available for you to use whenever you need to. You can pay them back either immediately or over time. Think of it like a flexible loan that comes with a predetermined amount of money you can use as needed.
For example, you could take out a line of credit for sudden medical expenses knowing that you won't be able to pay them back right away. This could be line of credit of $10,000 that lasts about 5 years. This option allows you to avoid late fees or potentially higher annual percentage rates (APRs) that you could otherwise face with a credit card with an even lower credit limit.
Variable rate of interest
With lines of credit, the interest rate may change. The prime rate could impact changes to the APR. If they rise, the amount you must pay back could increase. On the other hand, if interest rates decrease, the amount of interest you owe may also be less. Just like adjustable rate mortgages (ARMs), there is some unpredictability depending on macroeconomic factors that determine presiding interest rates.
There are different types of lines of credit, however, and some of these may come with fixed interest rates.
Different types of lines of credit
In the same way there are different types of loans and credit cards, there are various forms of lines of credit. Some may be more applicable to you than others and come with different terms and conditions.
Personal line of credit
A personal line of credit (PLOC) works much like a credit card where you have access to a certain amount of money that you can borrow up to a maximum limit. You only pay interest on the amount that you use. A PLOC does not come with collateral (such as a car or a home). This could be useful for sudden expenses like medical bills.
Home equity line of credit
A home equity line of credit (HELOC) can be used when you're looking to use your home's value as a way of accessing more cash. For example, let's say you want to make a large purchase, but you don't have the money on hand. By borrowing against your home's equity (the difference between current market value of your home and what you owe towards your mortgage), you can use your home as a way of accessing more available credit. Much like other lines of credit, a HELOC can come with interest rates that are either fixed or variable.
Do lines of credit affect your credit score?
When you first open a line of credit, your score could suffer by a few points (similar to opening a credit card account or mortgage). This is due to the fact that the lender will want to run a hard inquiry or a "hard pull" to gather insights about your creditworthiness. Keep in mind that other factors are considered as well, such as credit mix and available credit. These factors help determine the amount of credit you can receive and the interest rates (depending on if it's a fixed or variable interest rate).
Opening lines of credit can also have a positive impact on your credit score. For example, making regular payments towards your line of credit can affect your credit score in a positive way. Because payment history accounts for such a large amount of your credit score, timely payments can help boost your credit score over time more than other factors like credit utilization or credit mix, though these are also important.
Finally, when you open a line of credit, you're increasing the amount of money accessible to you. If you are careful with how much money you use against this line of credit (in addition to your other credit card accounts) you could improve your credit utilization ratio. This is the proportion of all your balances to the total of your credit limits. For example, let's say prior to opening a line of credit, you had a total of $3,000 in debt and $6,000 available towards your credit, putting you at a 50% utilization ratio. After opening a line of credit of $3,000, your ratio is closer to 33%. This small shift in your credit utilization ratio can improve your credit score.
Why a line of credit may not be a suitable option
There are a few benefits that come with opening lines of credit—from helping you refinance your mortgage to improving your credit utilization ratio. However, it may not be necessarily what you need financially.
For example, you may be in need of a loan that you can have more time to pay off. In that case, a line of credit wouldn't be a suitable option—a fixed interest rate loan may be a better bet. With a fixed interest rate, you won't have to worry about the variable interest rate that comes with opening a line of credit, which could make paying back the loan more unpredictable. (Remember, though, that this could swing in the other direction where the interest rates trend lower.)
Fortunately, there are plenty of options outside of opening a line of credit that may work just as well if not better for you. Credit cards with low fees or loans with relatively low fixed interest rates could be more suitable for your situation.
Remember, regardless of whether you take out a line of credit or credit card/loan, having a good credit score will help you get approved and land lower APRs. When you have a strong financial foundation, you'll have even more opportunities to make your money work for you and your lifestyle.