The pros and cons of lines of credit

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Almost 30% of consumers in the top 100 metropolitan areas opened at least one new line of credit in the first half of 2023. 

A line of credit is a bit like a hybrid between a credit card and a traditional loan— letting you borrow money up to a certain limit (once qualified) while only paying interest on what you use. Now, they can be super handy in certain situations, but like any form of borrowing, they may have potential downsides. 

So whether you're considering opening a line of credit or want to understand this option better, this article will help demystify the benefits and drawbacks of credit lines.

What is a Line of Credit?

A line of credit can be used somewhat like a financial cushion you can tap into when needed. It's an arrangement with a lender (for example, your bank) that can allow you to borrow money up to a certain amount, known typically as your credit limit. 

Unlike a traditional loan, where you receive a lump sum upfront and start accruing interest right away, lines of credit give you the flexibility to borrow what you need when you need it. It's kind of like having a financial "tap" that can be turned on and off as needed.

On the other hand, lines of credit are similar to credit cards in some ways. Both give you a set spending limit and allow for revolving borrowing and repayment. However, lines of credit often have lower interest rates than credit cards, particularly for lower-risk borrowers with higher credit scores.

It's worth noting that there are a few different kinds of lines of credit:

• Secured lines of credit require you to put up collateral, like money from a savings account or the equity from your home, that acts as security for the lender in the event you default on the loan. This collateral often helps the borrower get a lower interest rate.

• Unsecured lines of credit don't require collateral but may have higher rates and be more difficult to qualify for due to the increased risk for lenders.

• Personal lines of credit are used for individual borrowing needs.

• Business lines of credit are designed for business expenses and cash flow management.

At Varo, we're dedicated to making financial products like lines of credit accessible to the everyday person. While we do not currently provide business lines of credit, our personal line of credit product, Varo Line of Credit¹ offers the same borrowing power of a traditional line of credit while avoiding the recurring interest. Instead, pay a one-time flat fee for each amount borrowed and pay funds back over a 3 to 12 month period (depending on amount borrowed). This also differs from a personal loan, as our line of credit does not require reapplication for future borrowing assuming you continue to meet eligibility requirements. 

Let's continue to the advantages and disadvantages of lines of credit.

The Pros of Lines of Credit 

Now that you have a basic understanding of a line of credit, let's explore some of the key advantages of this borrowing option, even for those who are not wealthy.

Access to Funds When You Need Them

Lines of credit can offer flexibility by letting you borrow what you need, when you need it. This could help manage cash flow or cover unexpected expenses like medical bills and car repairs.

Pay Only for What You Use

A major advantage of lines of credit is that you typically only pay interest on the amount you borrow, not the full credit limit. This can make them more cost-effective than loans, where you pay interest on the full amount regardless of how much of the available credit you borrow.

Potentially Lower Interest Rates

Lines of credit usually have higher interest rates than loans but lower rates than credit cards. The rate you get depends on factors like your credit score and the lender you choose. A line of credit may be a more affordable borrowing option for those with good credit.

Building Credit

Did you know that responsibly using a line of credit could help you rebuild your credit profile? By borrowing and repaying strategically over time, you could establish a positive payment history— which is one of the key factors in credit score calculation. 

Read more: How to get a line of credit with bad credit

The Cons of Lines of Credit 

While lines of credit offer some undeniable advantages, knowing the potential drawbacks is crucial before signing on the dotted line. Let's take a closer look at some of the downsides that could help with your decision.

Beware of High-Interest Rates

One of the biggest potential downsides of lines of credit are their recurring interest rates. While these interest rates are often lower than credit cards, lines of credit still typically have higher rates than traditional loans.

Note: Varo Line of Credit doesn’t come with any recurring interest on the funds you borrow. Instead, customers pay a flat, one-time fee that covers the entire amount of credit you borrow. For example, a $600 line of credit comes with a $60 fee, with a 3-month pay back period. After taking out a $600 line of credit with Varo, you would receive the funds instantly and repay $220, each month, for 3 months. 

Potential Extra Fees

Another thing to watch out for with lines of credit? Fees. Depending on the lender and the specific product, you may be charged a variety of fees, such as:

• Annual fees just to keep the account open

• Maintenance fees that are charged on a monthly or yearly basis

• Origination fees for setting up the account

• Transaction fees each time you make a withdrawal

• Late payment fees if you miss a payment due date

• Prepayment penalties if you pay off the credit line early

All of these fees can add up, increasing the overall cost of your borrowing.

The Temptation to Overspend

One of the biggest lines of credit risks can be the potential for overspending and accumulating debt. Because you have ongoing access to your credit limit, it can be tempting to lean on your line of credit in situations when it may not be necessary.

Budgeting with Variable Rates

If your line of credit has a variable interest rate (and many do), it can make budgeting and financial planning a bit trickier. Because rates can fluctuate over time based on market conditions, payments may also vary, which could throw off your budget.

Putting Assets at Risk

If you choose a secured line of credit, remember that collateral (like a savings account or your home’s equity) is on the line. If you default on your payments, the lender has the ability to  seize those assets in order to help recoup their losses. 

When to Use a Line of Credit

So when does it make sense to tap into a line of credit? While everyone's financial situation is unique, a line of credit can be a smart move in a few common scenarios.

Handling Unexpected Expenses

One of the most common uses for a line of credit is covering unexpected expenses. Whether it's a surprise medical bill, a car repair, or a sudden home maintenance issue, a line of credit can provide the funds you need to handle these costs without derailing your regular budget.

Funding Home Improvements

If you're planning a home renovation or remodeling project, a line of credit could be a way to finance some costs. Once qualified, you can borrow what you need as the project progresses and repay it over time. It may also be helpful to factor the interest and fees into your overall project budget.

Consolidating Higher-Interest Debt

Another potential use for a line of credit is consolidating other debts with higher interest rates, like credit card balances. By transferring those balances to a line of credit with a lower rate, you may save on interest and pay off your debt faster. 

Bridging Income Gaps

For professionals with irregular income streams, like freelancers or seasonal workers, a line of credit could help bridge the gap during slower employment periods. By borrowing what you need to cover expenses during lean times, you could keep things running smoothly until your income returns.

Starting or Growing a Business

Finally, lines of credit could be useful for entrepreneurs looking to start or grow a business. Flexible borrowing can help manage cash flow, cover inventory purchases, or fund other growth initiatives. Just be sure to have a plan for how you'll use and repay the funds.

Note: Varo Line of Credit is a personal line of credit. Varo Bank currently does not offer HELOCs or business lines of credit. However, we are consistently looking for new and innovative ways to improve the financial health of our customers’ lives.

When to Avoid Using a Credit Line

Of course, there are also times when tapping into a line of credit may not be the best move. Here are a few scenarios you might want to consider.

Covering Non-Essential Purchases

It can be tempting to lean on a line of credit for fun splurges or impulse buys, but that could be a slippery slope. Remember, you're borrowing money that has to be paid back, usually with interest, so using a line of credit for non-essential purchases could quickly lead to debt cycles.

When You Have Sufficient Savings

If you have a robust emergency fund that can cover unexpected expenses, it may be wiser to tap into those savings before turning to a line of credit. After all, your savings are yours free and clear, while borrowing always comes with associated costs.

If You Struggle with Overspending

A line of credit could also be a dangerous temptation for people who have trouble controlling their spending. If you know you're likely to max out the credit limit on non-essential purchases, then it may be best to avoid opening a line of credit.

For Long-Term, Predictable Expenses

If you have a major expense you know is coming and can plan for, like a car purchase, dream vacation, or major home renovation, a credit line may not be the best financing option. In these cases, you're usually better off saving up in advance or considering a traditional loan with a fixed interest rate and repayment terms.

Boost Your Personal Finance with One-Time Fee Credit Line 

As you explore your financial options, remember that the key to success lies in arming yourself with knowledge and making informed, strategic choices that support your long-term financial health and goals. 

At Varo Bank, we recognize the importance of having access to affordable, transparent borrowing options. That's why we've designed Varo Line of Credit¹ to help you cover unexpected expenses or bridge short-term cash flow gaps without the burden of high recurring interest rates or hidden fees. 

With the ability to borrow up to $2,000, no interest, and repayment terms between 3 and 12 months (depending on amount borrowed), Varo Line of Credit offers a straightforward borrowing experience for our customers. Pay a simple, fixed fee, and avoid the worry that comes with accruement of interest.

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.}