Pros and Cons of a Personal Line of Credit
If you need extra funds to remodel your home, cover a fun family vacation or just pay some bills, you could consider a personal line of credit as a potential option.
Here’s why one may or may not be a good option for you.
What is a personal line of credit?
Personal lines of credit fall somewhere between a credit card and a personal loan. You apply for one through a bank or a credit union, and, if approved, it will grant you access to a certain amount of money, which is yours to use as you need it for a set period of time. Limits generally range between $1,000 to $100,000, with terms between six months and five years, depending on your creditworthiness.
Personal lines of credit are typically unsecured, meaning you may not need any collateral to get one, and there are no limits as to how you could use the funds. Once you use a portion of the funds, you will have to start making monthly payments on that amount with interest (although you may already be paying monthly or annual maintenance fees). Beware that interest rates on personal lines of credit are variable, so there can be uncertainty around your monthly payments.
Personal line of credit pros and cons
Of course, like with all personal finance products, there are both pros and cons that come with personal lines of credit. Let’s start on a positive note.
- Flexibility: Flexibility is the prime benefit of personal lines of credit. There are typically no restrictions as to how you can use the funds, and you can use as little or as much as you like when you like. They’re perfect for ongoing projects. For example, if you’re renovating your kitchen, a personal line of credit allows you to pay for equipment and services as you go. (We’ll talk about home equity lines of credit as an alternative option later.)
- Gap filler: The check is in the mail, but that doesn’t help you if your bank account is bare. A personal line of credit may be a great way to fill financial gaps for freelancers or those whose income is largely commission-based. You can tap into your line of credit between paychecks instead of resorting to other, potentially more expensive options to pay your bills and other expenses, and then pay it back come payday.
- Rinse and repeat: As long as you pay back the funds, you may be able to “reuse” your personal line of credit as often as you like. For example, say you have a $2,000 line of credit, and you use it all to pay off a hefty car repair bill. Once you repay that “loan,” then you could access that $2,000 again for the life of the line of credit as many times as you pay it off.
While personal lines of credit offer some great advantages, there are also some other factors to consider that may not make them the right choice for everyone.
- Fees: In addition to the interest you must pay on the amount you withdraw, there may be maintenance fees (even if you don’t use the line of credit) as well as fees assessed each time you make a withdrawal from a personal line of credit. These terms vary by lender, so make sure you know what you’re signing up for to avoid surprises down the line.
- Variable rates: Unlike traditional loans, the interest rate on a personal line of credit is variable, so you can’t be certain what your monthly payments will be in the future. If interest rates drop, that’s great, but there’s also the possibility that you could see your required minimum monthly payment spike. Also, while the interest rate on a personal line of credit is typically lower than that of credit cards, it’s typically higher than the rates for personal loans and HELOCs.
- Temptation to spend: You should know yourself and your spending habits well before opening a personal line of credit. For some, knowing that money is so readily available can be too tempting, and they may find themselves using it for unnecessary expenses. Just remember, it’s not “free” money, and interest and fees can add up quickly.
- Debt is debt: While convenient, if you use your personal line of credit, it’s just like any other debt. It will be calculated into your credit score as revolving credit, and if you’re unable to make regular, on-time payments, your credit can take a significant hit.
3 alternatives to a personal line of credit
If a personal line of credit has you checking more cons than pros, there are other options to consider, including the following:
Unlike a personal line of credit, a personal loan grants you a lump sum of money. Your interest rate is locked in from the beginning, so you know exactly how much money you’ll have to pay back and don’t risk getting hit with a spike like you might with a personal line of credit, which has a variable interest rate.
There are typically no fees associated with personal loans, and in most cases you can use the funds for any expenses you like. Personal loans are also unsecured for the most part, meaning your home or other assets aren’t used as collateral and therefore aren’t at risk if for some reason you’re unable to repay your loan. That makes personal loans a particularly good option for debt consolidation, unlike personal lines of credit.
Choose a personal loan if … You know how much money you need and want to potentially secure a lower interest rate than on a personal line of credit.
Home equity line of credit
A HELOC is a secured loan, which uses the equity you’ve built in your home as collateral. Because there’s less risk for the lender, the interest rate on HELOCs is typically lower than for personal lines of credit. Beyond that, they operate mostly in the same way, allowing you to withdraw funds as necessary and only pay interest on the amount if and when you do.
Just remember that your home is on the line, so you want to make sure you’re able to repay any funds you withdraw. Also, the interest rate of a HELOC is variable, so you’re never quite sure how much you could end up owing, unless you secure one with an interest rate cap.
Choose a home equity line of credit if … You want a lower interest rate, have equity in your home and are comfortable using your property as collateral.
And, of course, there’s always plastic. While the interest rates for credit cards tend to be higher than those of other options we’ve discussed, as long as you pay off your balance every month, they can be a convenient (albeit a little too convenient sometimes) way to pay for ongoing and/or unexpected expenses. In some cases, you can also rack up travel rewards, cash back or other perks while doing so.
Choose a credit card if … You want the flexibility to choose between credit cards that may offer a 0% introductory APR, no annual fee or rewards, such as cash back or airline miles.
Before making the decision to apply for a personal line of credit or one of the alternatives above, it is important to assess your financial situation and research all your options.