What is a personal line of credit?
Small business owners and entrepreneurs are often looking for various sources that help them fund their business. While there are plenty of options available today, personal loans and personal lines of credit continue to enjoy popularity. One may wonder, what is the difference and what makes these options popular?
Businessmen sometimes require cash flow and liquidity in their business. For this purpose, they may choose to opt for a loan or a line of credit. If a food manufacturing company wants to install a new machine, they may opt for a personal loan if they cannot afford to make the payment upfront. But in case a business requires cash flows for its recurring expenses like employee payrolls, overheads, etc., you can choose to opt for a personal line of credit. The bank or the credit union that issues this personal credit line will give you a monthly limit of withdrawing funds. This is more useful than a credit card, which only gives you the option of repaying later.
Where can a line of credit be used?
Startups and small businesses are often bootstrapped, which leaves the owner with very tight funds for his own personal expenses. And therefore, a line of credit is useful for making small cash withdrawals for activities like:
- Home improvement
- Tuition fees for your children’s school or college
- Unplanned activities and expenses
- Major repairs to any household appliances or office equipment
- Debt consolidation
- If your income is not fixed like freelance jobs or contractual jobs, or seasonal assignments
Generally, there aren’t many restrictions on the usage of funds for a personal line of credit. It helps give you financial safety when your business is still starting up, and you do not have a steady flow of income.
The biggest advantage of a personal line of credit is that you pay interest only on the amount of credit you use, not the entire approved amount. In that way, you are always in control of your expenditure.
In general, a personal line of credit has very few restrictions in terms of its use. You can even use it as a cash cushion if you want a little extra financial safety or anticipate an expense in the future. For instance, during this pandemic, there is a lot of uncertainty about jobs. In such a situation, you can get a personal credit line approved and use that cash IF a need really arises. The best thing is, if the need for that extra money doesn’t surface, you don’t even need to pay interest on the approved amount.
When Should you Consider Using a Personal Line of Credit?
A personal line of credit can be considered in the following situation:
- You are in urgent need of cash for business expenses or home expenses
- You want a lower rate of interest than a credit card
- You need cash for recurring expenses
- You want the flexibility of making withdrawals in smaller denominations and paying interest only on the used amount
- You want a cash cushion for safety
- You do not want to give collateral for security
- You have fluctuating income, which either seasonal, freelance income, etc.
- You are not sure of how much amount you will need
When Should you Avoid a Person Line of Credit?
You may want to avoid a personal line of credit and opt for another credit source in the following situations:
- You need credit for a specific purpose or expense, e.g., Installing new machinery for your business
- You want a fixed rate of interest
- You are looking for a long term repayment option
- You have a low credit score
- You know exactly how much money do you need
How can you Qualify for a Personal Line of Credit?
Qualifying for a credit line is relatively easy. Here are the three things that will help you become eligible for a credit line:
- A good credit score: A stable credit score with lesser hard inquiries helps you negotiate a better interest rate and easier repayment options on the credit line
- Ability to repay the loan: Minimise your debt-to-income ratio as much as possible. This will enforce trust in you that you shall be able to repay the money and help you qualify for a credit line.
- Documentation in order: Have all your information, necessary documents, and paperwork in place.
You must understand that credit cards, personal loans or even lines of credits are tools to back financially in your business endeavour. Use them judiciously, but do not make them substitutes. If used wisely, they can help you get through challenging times with an extra cash cushion. But if misused, the same tools may even be responsible for increasing your debt. So, it is best advised that you study every tool and make a wise decision after weighing every tool’s pros and cons based on your unique requirement.
Lily Tran is a content writer, working for MoneyTap, who writes about all things Finance. Her passion for credit, debt, loan & investment drives her to help readers get an insight about everyday finance.