How lines of credit can affect your credit score

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Over the past year, the use of revolving credit (including lines or credit and credit cards) has increased by 10.2%. Despite this increase in credit usage, many individuals still don’t fully understand what a line of credit is, or how using one can affect your credit score.

A line of credit is a flexible financial tool that gives you access to a predetermined amount of money you can borrow as needed. It’s similar to a credit card but typically used for larger expenses or as a safety net for unexpected vehicle repairs, medical bills, or to help consolidate other debt. More importantly, when you use a line of credit responsibly, borrowing only what you need and making timely payments, it could have a positive impact on your credit score.

In this article, we'll dive into what a line of credit is, how it works, how it can contribute toward better financial management and improved credit. Whether you're familiar with credit basics or seeking ways to enhance your financial health, understanding lines of credit can provide valuable insights into better financial planning.

What is a Line of Credit?

A line of credit is a flexible loan that allows you to borrow money up to a predetermined limit, and can be a great option for additional finances for unexpected expenses or for taking advantage of opportunities that require immediate funding, such as last-minute expenses or essential home repairs. One of the most attractive aspects of a line of credit is that you only pay interest on the amount you actually borrow, not the entire credit limit. Some lines of credit also offer borrowing for a single flat fee instead of recurring interest, but these are usually less common.

Read more: The advantages and disadvantages of lines of credit

How do lines of credit work?

• After applying, your lender approves you for a specific credit limit based on factors like your income, credit history, and debt-to-income ratio.

• You can then access funds from your line of credit as needed, whether it's for a planned expense, like a home renovation, or to compliment your emergency savings fund in unexpected situations.

• As you repay the borrowed money, your available credit is replenished, allowing you to borrow again if needed.

• Interest is charged only on the outstanding balance, not the entire credit limit available.

How a Line of Credit Differs From Other Borrowing

Credit cards

Credit cards and lines of credit usually share the revolving credit model, allowing borrowers to draw funds, repay, and redraw as needed (up to the approved limit). Despite this similarity, credit cards often come with higher interest rates compared to lines of credit, reflecting potentially higher costs for the user. Additionally, credit cards might also carry annual fees, adding to the overall expense of maintaining the credit account. This contrasts with some lines of credit, which may offer lower variable interest rates and, in many cases, no annual fees, presenting a more cost-effective option for ongoing access to funds.

Personal loans

A key distinction of personal loans lies in the borrowing and repayment structure. Personal loans offer a one-time lump sum of available funds, which you repay through fixed monthly payments over an agreed period. This structure is often accompanied by a fixed interest rate. In contrast, a line of credit provides flexible access to funds up to a certain limit without the need to reapply after each use. Once approved for a line of credit, you can usually draw from its limit multiple times, given you adhere to the lender's terms. Unlike personal loans, many lines of credit feature variable interest rates as well, adding an element of fluctuation in borrowing costs.

• Note: Like a traditional personal line of credit, Varo Line of Credit¹ provides access to a set limit— however, we don’t charge variable or recurring interest. Instead, you pay a flat one-time fee based on the amount borrowed and pay funds back over a given amount of time. 

The flexibility of a line of credit can make it a useful tool for managing your finances. You can borrow what you need, when you need it, and only pay interest on the amount you use. Just remember, as with any form of borrowing, it's essential to use your line of credit responsibly and make timely payments to maintain healthy credit.

Types of Lines of Credit

There are mainly three types of lines of credit: personal, home equity, and business. Each type has its own unique features and qualification requirements. Let's explore them in more detail.

Personal Lines of Credit

• Can be secured or unsecured. Secured credit lines are backed by collateral, while unsecured lines of credit are based on your creditworthiness.

• Qualification requirements may include a minimum credit score, proof of income, and a low debt-to-income ratio.

• Typically have lower credit limits than other lines of credit types.

• Interest rates may be higher than secured lines of credit.

Home Equity Lines of Credit (HELOCs)

• These are secured by the equity in your home.

• The credit limit is usually based on a percentage of your home's value minus any outstanding mortgage balance.

• HELOCS often have lower interest rates compared to unsecured lines of credit.

• The risks include potentially losing your home if you default on payments along with reduced home equity as you borrow against it.

Business Lines of Credit

• These are usually designed for small business owners to access funds for various business expenses.

• Business credit lines can be secured (backed by business assets) or unsecured (based on business creditworthiness).

• The qualification requirements may include time in business, annual revenue, and business credit history.

• The interest rates may be higher than personal lines of credit but lower than some business credit cards.

If you're a homeowner, a HELOC may offer lower interest rates, but it also comes with the risk of losing your home if you can't make payments.

Personal lines of credit usually have higher interest rates than HELOCs but can be a good option if you don't want to put your home at risk. Business lines of credit are specifically designed for business owners and can provide the flexibility needed to manage cash flow and invest in growth opportunities.

Does a Line of Credit Affect Your Credit Score?

A line of credit, whether revolving or non-revolving, has the potential to influence your credit score. Revolving lines of credit, similar to credit cards, allow you to borrow, repay, and re-borrow funds again up to your available limit. Non-revolving lines, on the other hand, can give you a one-time fund disbursement, which you pay back over a fixed period. 

Responsible management of either type, characterized by making timely and complete payments, can significantly contribute to healthy credit. This aligns with the idea that diligent and responsible credit management, across all forms of credit, can play a fundamental role in establishing and maintaining good credit over time.

Several factors can affect your credit score when using a line of credit, including credit utilization, payment history, the age of credit accounts, and your overall credit mix. These various aspects create a comprehensive understanding of your financial health.

Let's look closer at how lines of credit can impact each of these factors.

Credit Utilization Ratio

• Your credit utilization ratio is the percentage of credit you're using compared to your total available credit.

• It's a key factor in your credit score, with experts recommending keeping your utilization below 30% at a minimum, but ideally under 10%.

• Unlike credit cards, lines of credit don't usually impact your credit utilization ratio until you actually borrow against them.

Payment History

• Late or missed payments can damage your credit score if they are more than 30 days late and can stay on your credit report for up to seven years.

• It may be helpful to set up automatic payments or reminders to ensure you never miss a due date.

Length of Credit History

• Opening a new personal line of credit could lower the average age of your credit accounts, which may slightly decrease your credit score initially.

• However, maintaining a personal line of credit over an extended period with on time payments can help build your credit beyond where it started by demonstrating a long-standing relationship with a lender.

• It may also be important to avoid opening too many new lines of credit in a short period, as lenders may consider this a red flag.

Credit Mix

• Having a diverse mix of credit types—like credit cards, installment loans, and lines of credit—could positively impact your credit.

• Lines of credit add to your credit mix, demonstrating your ability to manage different types of credit responsibly.

• However, you shouldn’t open a line of credit solely to improve your credit mix, only do so if it makes sense for your individual financial situation.

The key is to use your line of credit responsibly, making timely payments and keeping your credit utilization low. In the next section, we'll share some strategies for using lines of credit to improve your credit score.

Strategies to Improve Your Credit Score Using Lines of Credit

Let's explore some strategies for using lines of credit to your advantage, which could help build and maintain strong credit over time.

Making On-Time Payments

Making payments on time is essential for maintaining a good credit score, as payment history is a key factor lenders look at, according to FICO. This shows lenders you're likely to pay all debts as agreed. Here are ways to ensure timely payments:

Set Up Automatic Payments: One straightforward method to help avoid missing due dates is by setting up automatic payments. This can usually be done through your financial institution and ensures your minimum payment or a set amount is automatically deducted from your account each month.

Use Reminders: Alternatively, setting up reminders a few days before your payment is due can help you remember to make the payment. This may be useful if you prefer to manually control the amount you pay each month, allowing you to potentially pay more than the minimum and help decrease your overall balance.

Pay More Than the Minimum: Whenever possible, you may also want to aim for paying more than the minimum payment required. This strategy can help decrease your outstanding balance faster and can also reduce the amount you pay in interest over time.

Keeping Credit Utilization Low

Managing how much of your available credit you use can be another crucial aspect of improving your credit score. Here are strategies to keep your credit utilization in check:

Stay Below 30% Utilization: A widely recommended guideline is to use no more than 30% of your total available credit limit across all accounts, although below 10% is even better. This behavior shows lenders that you can manage your credit responsibly without maxing out all of your available resources.

Pay Balances Before Statement Closing Date: To ensure that a low credit utilization ratio is reported to the credit bureaus, it may be beneficial to try and pay down your balances before the billing cycle ends. This strategy could help keep your reported utilization ratio lower, even if you use your credit more during the month.

Spread Out Large Purchases: If you are planning a significant expenditure that could push your utilization over 30%, you may want to consider breaking it up over several billing cycles. This approach could help avoid sharp increases in your credit utilization ratio, which can negatively impact your credit.

Using Lines of Credit for Expenses

Lines of credit can be versatile financial tools that can serve multiple purposes in managing your finances. When used judiciously, they can be particularly effective for covering both planned and unforeseen expenses:

Financing Planned Expenses: For significant purchases such as home renovations or large purchases that you’ve anticipated and budgeted for, a line of credit could offer the flexibility of accessing funds as needed, often with better interest rates than typical credit cards. This could make it an ideal option for managing the costs associated with such projects while allowing you to repay the borrowed amount over time.

Solution for Unexpected Expenses: Life can be unpredictable, presenting us with sudden financial emergencies like car repairs or medical bills. In these scenarios, having a line of credit could be invaluable, offering immediate access to funds that can cover these unplanned costs without derailing your financial stability.

Avoiding Overreliance on Non-Essential Spending: While lines of credit offer flexibility and access to funds, it’s important to use this financial tool wisely. Leveraging a line of credit for everyday spending that exceeds your budget could lead to mounting debt and financial strain. When weighing these factors, it could also be important to differentiate between essential expenses and non-essential spending, reserving the use of your line of credit for essential expenses to promote better financial health.

By treating your line of credit as a strategic financial resource, you could leverage it effectively for necessary expenses while avoiding the pitfalls of excessive reliance and debt accumulation.

Continuous Credit Monitoring

Keeping a close eye on your credit could be essential for maintaining financial health and ensuring the accuracy of your credit history.

Accessing Free Annual Credit Reports: According to federal law, everyone is eligible to receive one free credit report each year from each of the three major credit bureaus—Equifax, Experian, and TransUnion. These reports offer a snapshot of your credit activities, making it essential to review them to ensure all information is accurate and up to date.

Checking for Accuracy and Fraud: Regular review of your credit reports allows you to verify that all listed accounts and activities are accurate and belong to you. This step could be important for spotting any irregularities or possible signs of fraud and identity theft early on, safeguarding your financial welfare and credit standing.

Using Credit Monitoring Services: To further protect your credit, you may want to consider using credit monitoring services. These services can track your credit, notify you of any significant changes, and alert you to potential suspicious activities on your accounts. Many financial institutions, banks, and credit bureaus offer such services— sometimes at no additional cost.

Tracking Credit Improvement: If you’re working on enhancing your credit, regularly checking your credit can be a motivating action. Watching your credit score change over time can give you valuable feedback on the effectiveness of your financial strategies and help you stay focused on your credit goals.

Remember, building and maintaining a strong credit takes time and discipline. By using your line of credit responsibly and implementing these strategies, you could demonstrate your creditworthiness to lenders and unlock access to better financial opportunities in the future.

Read more: How to Get a Line of Credit with Bad Credit

Next, let's discuss some of the potential drawbacks and risks associated with lines of credit.

Drawbacks and Risks of Lines of Credit

While lines of credit offer flexibility and can be a useful financial tool, there could be some inherent risks and disadvantages to be aware of:

Variable Interest Rates: One of the main drawbacks is that lines of credit often come with variable interest rates. This means the cost of borrowing and your monthly payments could increase if interest rates rise, potentially making it more expensive than anticipated.

Note: Varo Line of Credit does not have variable interest, or even recurring interest. We instead offer borrowing for a transparent, one-time flat fee.

Risk of Overspending: The easy access to funds provided by a line of credit can sometimes tempt you into using it for non-essential purchases. This could lead to overspending and potentially trap you in a cycle of debt that can be hard to escape from.

Impact on Credit Score and Risk of Foreclosure: Missing payments on your line of credit can have severe consequences for your credit. For lines of credit secured against your home, like a Home Equity Line of Credit (HELOC), defaulting could even put your home at risk of foreclosure.

Important Considerations: It can be crucial to carefully review the terms and conditions of any line of credit that you are considering. Set a realistic budget and strictly limit its use to necessary expenses only. This approach can help mitigate the risks associated with borrowing.

Alternatives to Lines of Credit

If you're uncertain about whether a line of credit suits your financial needs, exploring other options could also be beneficial. Alternatives might offer more predictable costs or better align with your financial situation.

Personal Loans: Personal loans offer a fixed amount of money, which you repay in fixed monthly installments over a set term. They have fixed interest rates, which can provide greater predictability and stability compared to lines of credit. They could be a good option for financing larger expenses or consolidating high-interest debt.

Credit-Builder Loans: Credit-builder loans are designed to help individuals with limited or poor credit history build or rebuild their credit. The loan amount is usually held in a savings account, and you make monthly payments to help build up your credit history.

Secured Credit Cards: Secured credit cards require a cash deposit that serves as collateral for your spending limit. They may be  a good option for those building or rebuilding credit, as they typically have lower qualification requirements than unsecured cards.

If you're looking to establish or improve your credit score with a secured credit card, Varo may be able to assist you in developing responsible financial habits with Varo Believe²—our secured credit card which does not require a security deposit and does not have an annual fee, credit check, or interest.

Varo Believe is particularly helpful for those with poor or thin credit histories, as they are more likely to see a positive impact on their score by using the card and making consistent timely payments. Varo customers who use the Believe card and make on-time payments for three months see a 42-point increase in their credit score on average³.

In Conclusion

Lines of credit can offer a versatile way to handle your financial needs, but you should be mindful in their use. Responsibly managing a line of credit means making payments on time, maintaining low credit utilization, and keeping tabs on your credit score to build a healthy financial profile.

For those interested in a line of credit without the burden of interest charges, consider Varo Line of Credit¹. It provides an opportunity to borrow from $600 up to $2,000 for a fixed one-time fee, with repayment periods ranging from 3-12 months depending on the amount borrowed. We take your current Varo account activity into consideration when determining borrowing limits, among other factors, and you never need to worry about late fees or prepayment penalties. With increased activity on your Varo account comes the chance at increased borrowing limits, providing more financial flexibility over time.

Get started with Varo today or click to learn more about Varo Line of Credit!

^{1 The Varo Line of Credit is designed to help customers with unforeseen expenses with monthly payments, no late fee, no prepayment penalties, and no interest. To be eligible, your accounts must maintain a positive balance. Minimum monthly deposits, average daily balances, and other eligibility requirements apply. Once qualified for Varo Line of Credit, you will be assigned a credit limit from $600 to $2,000. A one-time fee is added to your borrowed amount, early repayment of your advance does not reduce the one-time fee. Your credit limit may fluctuate from one advance to the next based upon a variety of factors. You may only take one Varo Line of Credit out at a time. Your eligibility information and/or credit limit is always available to you in the home screen of your Varo app. Checking offer eligibility will not impact your credit score. If you are eligible and choose to apply for an offer, we will pull your credit and your credit score may be impacted.}

^{2 The Varo Believe Secured Credit Card is designed to help you build your credit; however, a variety of factors impact your credit and not all factors are equally weighted. Building credit may take time and Varo Believe may be able to help when you consistently make on-time payments.}

^{3 After three months of timely payments on the Believe card and no late payments on other credit, Varo Customers who had an existing VantageScore® 3.0 credit, on average, saw an increase in that score of approximately 42 points.  Individual results may vary, and some customers may not see a score increase.}