What is a Line of Credit?

A line of credit (also called a credit line or credit limit) is the maximum amount of money a bank will lend to an individual or business without requiring additional approval. The lender determines a line of credit based largely on the individual's credit worthiness and income potential. Certain large corporations and high-profile public figures have such a substantial line of credit they can literally borrow money against it for a lifetime.

Having a line of credit is very useful for small business owners who may have to take out several loans over time to purchase equipment or upgrade their facilities. Instead of applying for one $25,000 bank loan, for example, a business owner with a $25,000 line of credit can take out a $5,000 loan in April, then a $10,000 loan in August and finally a $2,000 loan in December, all with prior approval from the lender. By using a line of credit, borrowers can take out just enough money for a specific expense then pay it back entirely before taking out additional funds.

The amount of interest charged for each smaller loan in a line of credit can be variable. The first loan may have been taken out when lending rates were low, but the second might be affected by an upward or downward change in the prime lending rate or other factors. Banks can also charge penalty fees for late payments on ALL outstanding loans. Borrowers must keep track of individual loan obligations in order to keep payments on track.

Most people encounter a line of credit when dealing with credit cards or home equity loans. The credit card company establishes an upper limit on charges made by individual cardholders. This line of credit may be adjusted by customer request or by the company itself. Severe financial penalties may be levied on cardholders who borrow more money than their line of credit will allow. Credit cards do allow holders to make several purchases without seeking the approval of the lender.

Home financing options may also include a line of credit based on the value of the borrower's home. This practice is often called a home equity line of credit and is a genuine temptation for cash-strapped homeowners. Similar to a second mortgage, a home equity line of credit establishes a maximum amount of money a homeowner can borrow. In the case of a second mortgage, the bank lends the entire amount of money and the borrower makes regular payments based on the balance due. A line of credit arrangement, however, allows the homeowner to borrow smaller amounts of money to pay off contractors or bills without incurring a large debt up front. Financial experts are divided on the benefits of this form of 'line of credit' borrowing, however, so those interested in pursuing a home equity line of credit arrangement should do their homework first.