Line of credit
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A line of credit is a credit facility extended by a bank or other financial institution to a government, business or individual customer that enables the customer to draw on the facility when the customer needs funds. A line of credit takes several forms, such as an overdraft limit, demand loan, special purpose, export packing credit, term loan, discounting, purchase of commercial bills, traditional revolving credit card account, etc. It is effectively a source of funds that can readily be tapped at the borrower's discretion. Interest is paid only on money actually withdrawn. Lines of credit can be secured by collateral, or may be unsecured.
Lines of credit are often extended by banks, financial institutions and other licensed consumer lenders to creditworthy customers (though certain special-purpose lines of credit may not have creditworthiness requirements) to address fluctuating cash flow needs of the customer. The maximum amount of funds a customer is allowed to draw from a line of credit is typically called the credit limit or overdraft limit. The term credit limit is commonly used for credit cards whereas the term overdraft limit is more commonly used for bank accounts.
Unsecured vs Secured LOCs
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Most personal lines of credit are unsecured. This means the borrower does not promise the lender any collateral for taking an unsecured line of credit. One exception is home equity lines of credit (HELOC), which are secured by the equity in homes.
From the lender’s perspective, secured lines of credit offer lender the right to seize the asset in case of non-payment
From the borrower’s perspective, secured lines of credit typically come with a higher maximum credit limit and significantly lower interest rate than an unsecured credit line.
On the other hand, unsecured lines of credit have higher interest rates than secured lines of credit. A borrower must have a high credit score and good repayment history to meet the eligibility criteria for getting an unsecured line of credit. Since the unsecured credit line is not backed with collateral, if the borrower defaults on payments, the lenders cannot recover their losses. Hence, the lenders minimize their risk by charging high-interest rates and restricting the credit line limit.
Revolving vs close-end LOCs
A revolving line of credit allows a borrower to repeatedly draw money, up to their credit limit. It has a monthly payment and works similarly to a credit card.
A closed-end line of credit, on the other hand, has a fixed term. The term is divided into a draw period, where the borrower can draw money from the LOC as needed up to their credit limit, and a repayment period, where they can no longer draw money and are required to make monthly payments.
A cash credit is a short-term cash loan to a customer. A bank provides this type of funding, but only after the required security is given to secure the loan. In cash credit, the bank advances a cash loan up to a specified limit to the customer against a bond or other security. Once a security for repayment has been given, the business that receives the loan can continuously draw from the bank up to a certain specified amount.
In India, banks offer cash credit accounts to businesses to finance their "working capital" requirements (requirements to buy raw materials or "current assets", as opposed to machinery or buildings, which would be called "fixed assets"). The cash credit account is similar to current accounts as it is a running account (i.e., payable on demand) with cheque book facility. But unlike ordinary current accounts, which are supposed to be overdrawn only occasionally, the cash credit account is supposed to be overdrawn almost continuously. The extent of overdrawing is limited to the cash credit limit that the bank sanctioned. This sanction is based on an assessment of the maximum working capital requirement of the organization minus the margin. The organization finances the margin amount from its own funds.
Business line of credits
A business line of credit is quite similar to personal lines of credit. The financial institution grants access to a specific amount of financing. A business line of credit can be unsecured or secured (typically, by inventory, receivables or other collateral) Lines of credit are often referred to as revolving and can be tapped into repeatedly. For instance, if there is access to a $60,000 line of credit and $30,000 is taken out, access to the remaining $30,000, if necessary, remains. If all $30,000 is paid back, there is access to the entire $60,000 without having to reapply, one of the biggest benefits of a line of credit.
Costs and interest
The bank or financial institution will normally charge a fee for setting up a line of credit. The fee would typically cover the cost of processing the application, performing security checks, legal fees, arranging collateral, registrations, besides other things.
Normally, no interest is payable under the line of credit until the customer actually draws on a part or all of the credit facility. There may also be a fee for keeping the credit facility open, which may be a monthly, quarterly or annual fee. This may be called an “unused line fee”, which often is an annualized percentage fee on the money not withdrawn. Credit card companies typically charge an “annual account fee”; they also typically apply complex interest charging rules, such as no interest being payable on purchases if the account is paid in full by the monthly due date, interest is payable on cash withdrawals from the day of such withdrawals, minimum monthly repayment amounts, etc.