Line of Credit in Banking : What it is and How it Works

In the banking industry, Line of Credit (LOC) is a widely acknowledged term. Basically, an LOC is a financial agreement between a lender and a borrower that presets the borrowing limit. The borrower can use the funds whenever needed, repay them over time and borrow again if required. Both personal and business customers of lending institutions can avail of the facility of the line of credit. 

In this blog post, we shall explain what the line of credit in banking is. If you’re in need of extra funds, it is essential for you to know how the line of credit works. 

What is Line of Credit?

Line of credit meaning can be described as “a financial agreement between a borrower (individual/business) and a lending institution (such as a bank or an NBFC) wherein the borrower is allowed to access a set amount of money as needed.” 

The borrowing limit is set by the lender on the basis of the borrower’s creditworthiness. The borrower can access the line of credit loan at any time as long as it does not exceed the credit limit i.e., the maximum amount agreed upon by the lender and borrower. 

An interest rate is charged on the line of credit loan. This rate can differ from one bank to another. Many banks provide Line of Credit Loan Calculator on their official websites, such as Bank of Baroda, Axis Bank, and Bank of India. By using this calculator, you can check estimated interest amount, monthly payments, and repayment schedule on the basis of the loan amount and tenure selected.

To use the Line of Credit Loan Calculator, you must enter details like loan amount you require, loan tenure and interest rate. 

How does a Line of Credit work?

A line of credit is more similar to a credit card than a traditional loan because it gives you a set amount of money to borrow as needed. You can get a line of credit in a wide range of amounts, from Rs. 10,000 to Rs. 1 lakh or a much higher amount. 

LOC in banking is different from a traditional loan, where the borrower receives a lump sum of money at once and is required to repay it over time. Line of credits allows the borrower to spread out their usage over days, months or even years. The borrower only needs to repay what they have actively borrowed. Learn What happens if the Borrower fails to Repay the Loan.

Let’s assume you need some extra funds to renovate your house. A traditional loan would provide you Rs. 1 lakh upfront if you are eligible for the same. You will have to start paying that amount almost immediately. 

However, in case of line of credit, you can get a line of credit for Rs. 1 lakh if you really think you will need that much amount for renovation. You can borrow this amount whenever you need, say for repairing your bedroom or upgrading your kitchen. 

You do not need to borrow the entire Rs. 1 lakh if you do not need it. You can borrow funds in smaller amounts with the line of credit. This makes it easier for you to pay back the amount borrowed and borrow again as and when you need it.

Line of Credit Loan: Advantages & Disadvantages

Herein, we have explained some key advantages and disadvantages of the line of credit loan. By going through them, you can make out whether you should opt for the line of credit or not. 

Advantages of Line of Credit Loan

LOC offers the following key advantages to the borrowers:

• The line of credit provides access to instant, ongoing funds.
• It is a great option for financing projects with unclear costs. 
• It offers flexibility similar to credit cards but may have lower interest rates.
• Many financial institutions offer collateral-free LOC.

Disadvantages of Line of Credit

Line of credit has certain drawbacks, including:

• It is generally more difficult to qualify for the line of credit loan compared to a personal loan.
• For more competitive rates, the borrowers may need to offer collateral (real estate, vehicle, fixed deposit, etc.)
• An unsecured line of credit may attract higher interest rates.
• Some LOCs charge fees for early repayment.

Conclusion

Line of credits are a great alternative to traditional loans. They offer more flexibility when it comes to borrowing and repayment. Individuals and businesses can opt for a line of credits to access funds as needed without having to commit to a fixed loan amount. While a traditional loan provides a defined amount of money, a line of credit provides flexible access to funds up to a preset limit. As a result, borrowers can withdraw only what is needed and pay interest only on the amount they have used. 

FAQs about Line of Credits

Q1. What is a Line of Credit in banking?
A. A Line of Credit is a financial arrangement that allows individuals/businesses to access funds up to a set limit from a lending institution.

Q2. What are the risks associated with a Line of Credit?
A. The risks associated with a Line of Credit are overborrowing, high interest rates, credit score decline, asset seizure and fees associated with late payment.

Q3. Can I withdraw money from a Line of Credit?
A. Yes, you can withdraw money from a Line of Credit up to the credit limit approved by the lender.

Q4. How do banks earn money from a Line of Credit?
A. Banks earn money from a Line of Credit through interest charged on the borrowed amount.