What is a Line of Credit?
A Source of Pre-Approved Funds for Personal or Investment Purposes
Nov 7, 2009
A line of credit is an arrangement with a bank or financial institution where the customer has access to a pre-approved funds up to a specified amount. Usually the line of credit will be associated with a mortgage over an existing property as security for the loan.
Using a Line of Credit
The cash available in the line of credit account is available for the customer to use as and when required. The entire loan amount doesn't have to be accessed at the one time; a small amount can be taken out one day, a large amount the next and then maybe in a few days some cash is paid back into the line of credit account.
The cash in the account can usually be accessed on demand via the usual banking mechanisms: internet, linked to a credit card, over the counter at a bank, through an automatic teller machine. Like most accounts, interest is usually charged daily and allocated to the account monthly. So the interest payable is reduced whenever a payment into the account is made.
Investment Line of Credit
One of the main reasons for establishing a line of credit is for carrying out investment activities. For example, an investor may want to invest in shares on the stock market over a certain period. With a secure source of funds available, the astute investor can take advantage of the investment opportunities when they arise.
The pre-approval of the entire loan amount removes the need to keep running back to the bank or lending institution to get more funds. In the time it takes to do that, the investment opportunity may have disappeared.
This arrangement for an investment loan can also simplify things at tax time. In Australia, interest on money used to generate an income is generally tax deductible. So the interest charges will be easily reconciled at tax time with a line of credit as they are recorded in the line of credit account.
Line of Credit for Personal Use
A line of credit can also be convenient for personal use. Having a pre-approved source of funds available can iron out those sudden and unexpected requirements for cash. Such as the pet dog requiring expensive veterinary treatment; or maybe a new refrigerator is needed after the old one has died.
In these situations, the expense can be paid on the credit card to acquire the reward points. There is also more time to save some extra funds before the credit card payment is due. Then any excess funds needed to pay off the credit card can be drawn from the line of credit account.
This works because the interest rate on the line of credit is usually much lower than the credit card interest rates. The excess drawn out of the line of credit for the unexpected expense is then paid back into the line of credit account over a structured time frame.
Traps With a Personal Line of Credit
This arrangement doesn't work when the line of credit is looked on as an almost limitless source of cash. A line of credit is not this. Every dollar drawn out of the line of credit account for personal use, plus the acquiring interest, needs to be repaid at some time in the future.
For someone with a personal line of credit set up in this way, the general rule is that for any money drawn from the line of credit account there should not be any other cash lying around in other bank accounts, or under the bed. Every bit of cash should be put into the line of credit account to reduce the interest payments. When the line of credit is paid off, then it is time to move any excess cash into an interest earning account.
A line of credit is a useful mechanism for having funds readily available. However, care needs to be taken with ensuring the interest for personal and investment uses are clearly separated.
More information on this can be found in this Suite 101 article: Splitting Investment and Personal Line of Credit.
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