How do lines of credit work?

First, let’s talk about the options you have when you need to borrow money. Broadly speaking, you can usually apply for either a loan or a line of credit. With a loan, you get one lump sum of money and start paying interest immediately, regardless of when you use the money.

By contrast, a line of credit gives you access to a set amount of money that you can borrow when you need it. But you don’t pay any interest until you actually borrow.

There are business lines of credit, but we’ll look at lines of credit for personal use here.

Personal lines of credit are usually unsecured, meaning you don’t need to use collateral to take out the line of credit. Secured lines of credit are backed by collateral, such as your house or a savings account.

When you apply for a line of credit, having better credit scores could help you qualify for a lower annual percentage rate. Some lines of credit may come with fees, such as an annual fee, and limits on the amount you can borrow.

After you qualify for the line of credit, you’ll have a set time frame — known as the “draw period” — in which you can draw money from the account. A draw period can last several years. The bank may give you special checks or a card to use, or transfer the money to your checking account, when you’re ready to borrow the money.

Once you borrow money from your line of credit, interest usually starts to accrue and you’ll have to start making at least the minimum payments, the amount of which will be added back to your available line of credit as you make them. But once your draw period ends, you’ll enter the repayment period, in which you’ll have a set time to pay off any remaining balance. Keep in mind, making only minimum payments may cost you more in interest in the long run.

Secured lines of credit

One option if you’re looking to take out a secured line of credit is a home equity line of credit, or HELOC.

HELOCs allow you to borrow against the available equity in your home and use your home as collateral for a line of credit. They typically come with a variable interest rate, which means your payments may increase over time.

Generally, the bank will limit the amount you can borrow to up to 85% of your home’s appraised value, minus the balance remaining on your first mortgage. When banks set your interest rate, other factors besides your credit scores come into play, including your credit history and income.

If you’re not a homeowner or don’t want to use your house as collateral, you may be able take out a line of credit that’s secured against a savings account or certificate of deposit.

The downside for a secured line of credit? If you can’t make the payments, the lender may take the asset that secured the line.