What is Line of Credit and How does it work?

When faced with a cash crunch, a traditional loan is often the first option you may consider. When you avail a traditional loan, your lender provides a lump sum amount or the sanction, which is based on your loan eligibility. You have to repay this amount in monthly instalments, which are called EMIs or Equated Monthly Instalments. 

However, did you know that besides the several benefits of traditional loans, they also come with certain limitations as well? One of the main disadvantages of traditional loans is that you pay the interest on the entire amount right from the start. As such, it does not matter if you have used all the funds disbursed to you, your EMIs are set and you are expected to pay them in full every month. 

An easy way to sidestep this issue is by availing or opting for a line of credit (LOC). This is another lending product offered by financial institutions and it isn’t as popular as the traditional loan. However, it has its own share of advantages over traditional forms of loans in the market. 

Read on to get deeper insights on the line of credit loan and how it differs from traditional loans. 

A line of credit is quite similar to a traditional loan and it has many similar features. However, there are a few key differences you need to note. 

For instance, if you avail a line of credit, you can avail a specific loan amount from the lender, much like how traditional loans function. The main difference in a line of credit loan is that you need not take the entire loan amount in a single go. 

Instead, you have the flexibility to use your funds as and when required. You pay interest only for the funds used and not for the entire sanctioned loan amount. With this line of credit loan feature, your interest outgo is optimal as you only pay for the amount you utilise. 

In many cases, this credit solution is the cheaper alternative and can help you stay within budget. To help you understand better, consider the following example. You require only ₹20,000 for an emergency expense and you apply for a line of credit loan of ₹1 Lakh. 

Here, you only pay interest for ₹20,000 that you utilise and not for the entire loan amount of ₹1,00,000. As such, your EMIs will a lot more affordable, and your interest outgo will likely be lower too. 

A line of credit loan has useful features that can be highly beneficial for you as a borrower. Some of these include:

• The interest rates levied on a line of credit is generally lower than the interest rate applicable for personal loans.

• You need to pay interest only for the part of the loan amount you have withdrawn, instead of paying interest for the entire amount.

A line of credit loan also allows you to borrow a minimal amount of credit, which may not be typically possible with traditional loans. This is so because there is a specific requirement of a minimum loan amount you need to match in case of traditional loans. You may not be allowed to borrow anything less than the lower limit set by the lender. 

Owing to its unique features, a line of credit loan is suited for some specific purposes as mentioned below:

• A line of credit loan is the ideal financial tool for self-employed individuals. By opting for the line of credit, they can meet their business requirements without taking much risk.

• Alternatively, it is also useful for individuals without a regular source of income. This option provides necessary funds at regular intervals that help them manage low-business periods without much stress.

• Line of credit is also helpful in consolidating small debts. Instead of paying interest for small loans, you can combine them into one payment and clear it off by opening a line of credit. This helps you track your repayments easily.

• A line of credit is also ideal for managing expenses that require funding in staggered or irregular intervals. Common examples would include wedding or home renovations, wherein you can cover unexpected expenses easily with a line of credit. 

You can avail a line of credit loan through a number of banks and financial institutions. Make sure to meet the required parameters and submit the documents according to the requirements mentioned by the lender. 

The steps to apply for a line of credit are mentioned below:

• Step 1: Visit your preferred bank.

• Step 2: Ask them for a line of credit application form.

• Step 3: Fill in the form with all necessary details.

The bank will then check your credit score and disburse the amount. Note that the final credit amount and interest rate will depend on your credit score and monthly income among other factors.

It is a simple and hassle-free process to apply for a line of credit. Here is a list of some of the most common documents you may require to apply for a line of credit:

• Proof of identity, such as Aadhaar card, passport etc.

• PAN Card

• Proof of income documents, such as Form 16, ITR Returns etc.

• Proof of address, such as electricity bills, passport

• Bank statements for the past 6 months as proof of income

Once you submit these documents, lenders will verify them and assess your financial profile by checking your credit score and credit history. This assures the lender of your creditworthiness and if you are eligible to repay the line of credit loan on time. 

After a thorough scrutiny of these financial markers, your lender fixes an applicable interest rate for the line of credit facility. Do note that you have the option to apply for a line of credit through the offline and online modes. Choose a mode that is the most convenient for you and ensure to get sufficient funding for your needs.

The line of credit facility is inherently flexible. As mentioned above, you can withdraw funds as and when you require from your total sanctioned limit. You will be charged interest only for the used funds and not for the entire loan amount. 

Once you withdraw a specific amount from the line of credit, interest starts accumulating for the amount used. Based on the tenure chosen, you have to start repaying your loan amount. 

You may choose to either pay off the entire amount in one go or pay only a minimal charge depending on your cash flow and tenure of the line of credit loan.

A line of credit can have certain benefits for a business organisation. Consider going through the following tips to get the maximum benefit from a LOC:

• Make sure to plan how you are going to utilise the money.

• Avoid taking new loans before paying off your old ones, as this could lead to debt.

• It would be preferable if you could refrain from using your credit card until you have paid off your loan.

• Always calculate your current expenses as well as your upcoming ones to avoid missing future EMIs.

• Set aside a significant portion of your monthly budget to pay the monthly EMIs on time, even if only for a single month.

• If you have taken out a secured loan, keep in mind that failure to repay the entire amount plus interests on time may result in the loss of the valuable asset.

• If you are not comfortable with the monthly instalments repayment method, go for a quarterly payment.

• Avoid using  sanctioned funds to fulfil expensive dreams, such as going on a foreign trip or purchasing a car, as this type of poor planning can lead to massive debt.

• Always strive to pay more than the bare minimum. If you carry forward your EMIs to the next month, the bank will charge added interest on the EMI of your previous month.

• Consider repaying the credit amount as soon as possible.

A line of credit has a similar repayment option like that of a credit card. When you use funds from the loan limit, you have to repay back the amount within the set timeline. However, if you need funds again, you may withdraw them again even before you have repaid the first payment.

Consider that you have taken a line of credit for ₹2 Lakhs from which you had to withdraw ₹1 Lakh due to some emergency. You will be charged interest only for the withdrawn amount. 

However, if there is an additional cash requirement of ₹50,000 again, you may withdraw it from your limit. The interest will be charged now for the entire amount of ₹1,50,000 that needs to repaid within a specific deadline.

Here are a few pointers on how a line of credit differs from a traditional loan:

• In a traditional loan, the borrowed amount is disbursed entirely, but in a line of credit, an approved sanction is assigned to your account. Here, you can withdraw funds from this limit, as and when you require.

• While the payable interest is calculated on the entire loan amount in traditional loans, in a line of credit, the payable interest is calculated only on the amount withdrawn by you.

• Traditional loans come with specific regular periods of repayments known as EMIs, but in a line of credit loan, you have to repay the funds at a fixed date or you can prepay.

Some of the best loan products in the country can offer you unique features that make it easier for you to apply, avail, and utilise the loan amount you desire to meet any of your requirement. 

For custom-designed loans with benefits, flexibility, and repayment options you prefer, check out the umpteen options available on Bajaj Markets.

You can consider using a line of credit under the following circumstances:

• A line of credit may be a good idea if you need money for a home improvement project, education costs, or other types of major expenses — as long as you know you'll be able to repay it. 

• You can opt for this financing to consolidate several small debts into one payment with a lower interest rate to lower your overall cost of borrowing.

It is easy to track your line of credit. All you have to check is your monthly statement. To keep a regular tab on your line of credit, make sure to check the statement every month or every quarter. 

Try to clear the pending outstanding before you withdraw an additional amount. Be proactive and plan your monthly budget well ahead.