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What is a Line of Credit?
A Line of Credit (LOC) is a flexible financing arrangement that allows an individual or business to borrow funds up to a predetermined limit, repay them, and borrow again as needed. Interest is charged only on the amount actually used.
Definition
A Line of Credit is a revolving credit facility that provides access to funds up to an approved limit, with interest applied only to the outstanding balance.
Key Takeaways
- Provides flexible access to funds when needed.
- Interest applies only to borrowed amounts, not the full limit.
- Commonly used for working capital, cash flow smoothing, and short-term needs.
Understanding Lines of Credit
A line of credit differs from a traditional loan because it does not provide a lump sum upfront. Instead, borrowers draw funds as needed, repay all or part of the balance, and continue borrowing within the approved limit.
Lines of credit are widely used by businesses to manage cash flow fluctuations, cover short-term expenses, or finance inventory purchases. Individuals may use personal lines of credit for emergencies or large, irregular expenses.
Depending on the agreement, lines of credit may be secured (backed by collateral) or unsecured, and interest rates may be fixed or variable.
Formula (If Applicable)
While there is no single formula, key calculations include:
- Interest Cost: Outstanding Balance × Interest Rate
- Available Credit: Credit Limit − Outstanding Balance
Real-World Example
- A small business secures a $100,000 line of credit and draws $30,000 to cover payroll during a slow month, paying interest only on the $30,000 used.
- A homeowner uses a home equity line of credit (HELOC) to fund renovations as expenses arise.
Importance in Business or Economics
Lines of credit are important because they:
- Improve liquidity and financial flexibility.
- Help businesses manage seasonal or cyclical cash flow.
- Reduce the need for repeated loan applications.
- Support short-term operational stability.
Types or Variations
- Business Line of Credit: Used for operating expenses.
- Personal Line of Credit: Used by individuals for flexible borrowing.
- Home Equity Line of Credit (HELOC): Secured by property equity.
- Secured vs. Unsecured LOC: Based on collateral requirements.
Related Terms
- Revolving Credit
- Working Capital
- Short-Term Financing
Sources and Further Reading
- Investopedia – Explanation of lines of credit and how they work.
- U.S. Small Business Administration (SBA) – Guidance on business financing options.
- Federal Reserve – Credit market information and interest rate policy.
Quick Reference
- Credit Type: Revolving.
- Interest: Charged only on amounts used.
- Best For: Cash flow management and short-term funding.
Frequently Asked Questions (FAQs)
Is a line of credit the same as a loan?
No. A line of credit is revolving, while a loan provides a one-time lump sum.
Can a line of credit be reused after repayment?
Yes, as long as the account remains open and within the limit.
Do lines of credit require collateral?
Some do (secured LOCs), while others do not (unsecured LOCs).
