Lines of credit are a financial practice where credit is made available to consumers, often as a secured debt with collateral such as the consumer’s home. This line or credit, also known as a home equity line or credit is a common method of borrowing money by leveraging one’s most valuable asset. In addition to a home equity line of credit, lines of credit may be extended to businesses, depending on their needs. Business lines of credit are not lump sum payments, but rather a special bank account that affords the borrower flexibility in purchasing, paying bills and other liquidity needs. Interest is paid only on money withdrawn by the borrower, although there may be mandatory amounts that need to be borrowed in order to avoid inactive account fees or fees in form of interest on the money in the line of credit not withdrawn.
What are the costs of credit lines?
In addition to interest payments, there may be a number of fees associated with lines of credit, including application, property appraisal and lawyer fees. Some lenders will even charge preparation and filing fees. Interest rates on credits lines are almost always variable, although the lender and borrower may agree and the end of the term that line of credit was made available to repayment on a loan with a fixed interest rate.
What are the risks of lines of credit?
As with all secured debts, the failure to meet the terms of repayment may give the lender the right to collect the collateral that was leveraged to receive the loan. As such, an unpaid home equity line of credit can be grounds for the lender to foreclose on the homeowner that had received a line of credit.
Many lenders will place restrictions on lines of credit, requiring the borrower to borrow a certain amount of money per term, a minimum amount of money borrowed at a time, or specific conditions on minimum payments. Among the greater risks associated with lines of credit will be exploitive terms and conditions as well as variable interest rates. All lines of credit interest rates are based on an index, such as the “prime rate” which is usually the consensus of a survey of major banks’ interest rates. Changes in the prime rate tend to be reflected in interest rates offered to consumers. Many lenders will entice potential borrowers by offering low introductory rates, but luckily, for consumers, all interest rates for home equity lines of credit are capped at a certain level, determined by the lender.
Due to variable indexes, anyone that takes a line of credit without properly researching the index that the variable interest rate is tied to will risk unpredictability in the changes of the “prime” rate and may not be aware of volatility or historical highs associated with the index. Shrewd lenders will also include a “floor” in the agreement, ensuring that the consumer will never pay less than a set interest rate.