What is a line of credit? Everything you need to know

^{All Varo products and services mentioned below are contingent upon opening a Varo Bank Account. Qualifications may apply. Links to external websites are not managed by Varo Bank, N.A. Member FDIC.}

Have you ever needed extra funds but didn’t know where to turn? A line of credit could be the answer you're looking for. 

Despite the recent personal loan boom, many American households don’t currently utilize a personal line of credit. Understanding how lines of credit work may seem complicated, but our goal for this guide is to break credit lines down into easy-to-digest segments while sharing everything you need to know. Whether you need to cover unexpected expenses, finance a home improvement project, or just want a financial safety net, a line of credit can be a valuable financial resource.

Let's explore the world of lines of credit together. Our goal is to help you understand what lines of credit are, how they work, and how they could help you achieve your financial goals.

What is a Line of Credit?

A line of credit, offered by banks and credit unions, is a flexible borrowing tool that allows access to a set funds limit. You typically only pay interest on the money you use, helping you be efficient in managing finances Once repaid, these funds may become available again, providing you the freedom to borrow as needed.

Note: Like a traditional personal line of credit, Varo Line of Credit ¹ provides access to a set amount of cash— however, we don’t charge 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. 

How Does a Line of Credit Work

When you're approved for a line of credit, your lender will often set a maximum borrowing limit based on a variety of factors. These could include:

• Your credit score and credit history

• Your annual income

• Your debt-to-income ratio (DTI)

• Your current banking relationships

• The purpose of the line of credit

• Collateral, if applicable (usually only for secured lines of credit) 

Each lender sets their own criteria and weights these factors differently, making certain lines of credit easier or harder to obtain given different financial situations.

After being approved, you can borrow any amount up to that limit, with a predetermined interest rate or one-time fee. Once borrowed funds are repaid, your available credit will most often replenish, allowing you to borrow again when needed.

How Lines of Credit Differ from Personal Loans

The primary difference between a line of credit and a personal loan is that lines of credit don’t require you to reapply each time you want to borrow. Once you get approved for a line of credit amount, you are able to borrow against that limit as many times as you want, so long as you continue to make regular on-time payments and satisfy other eligibility requirements set by your bank or lender. With personal loans, you receive a one-time lump sum of money, and must apply again to access additional funds.

Why Use a Line of Credit?

There are pros and cons to lines of credit, but oftentimes, a clear advantage of a credit line is its flexibility. Funds can be used for virtually any purpose. Whether you’re covering unexpected medical bills, financing a home renovation, taking advantage of a business opportunity, or refinancing other loans, the flexibility of a line of credit could allow you to craft your own financial strategies. Since you only pay interest (or in some cases, a one-time fee) on the amount you borrow, they could also be more cost-effective than other types of borrowing.

If you’re just a regular person, a personal line of credit could help you manage cash flow more effectively while keeping your savings intact. Business owners can also take advantage of lines of credit if they are experiencing fluctuations in revenue throughout the year or need to capitalize on new opportunities (note that while Varo does not offer a business line of credit at this moment, we are always exploring innovative approaches to support our customers in achieving and maintaining their financial health).

Types of Lines of Credit

Now that you have a basic understanding of a line of credit, let's explore their two main categories: secured vs unsecured.

Secured Lines of Credit

A secured line of credit is backed by collateral, an asset that the lender can seize if you fail to repay the borrowed funds. The most common type of secured line of credit is a Home Equity Line of Credit (HELOC). With a HELOC, your home serves as collateral, and you can typically borrow up to 85% of your home's value minus the amount you owe on your mortgage.

Other types of secured lines of credit include:

• Car title line of credit: Your vehicle serves as collateral

• Savings account line of credit: Your savings account balance acts as collateral

• Certificate of Deposit (CD) line of credit: Your CD is used as collateral

Because secured lines of credit are less risky for lenders, they often come with lower interest rates and higher borrowing limits than unsecured lines of credit.

Unsecured Lines of Credit

An unsecured line of credit doesn't require any collateral. Instead, lenders usually rely on your creditworthiness and income to determine eligibility and borrowing limits. The most common types of unsecured lines of credit are personal lines of credit and business lines of credit.

Personal lines of credit: These can be used for personal expenses, such as home improvements, medical bills, travel, or refinancing of other loans. Interest rates are typically higher than those of secured lines of credit, but some offerings, like Varo Line of Credit, can provide funds for a single flat fee.

Business lines of credit: These are designed for small business owners who need access to funds to cover short-term expenses or take advantage of opportunities as they arise. They can be used for inventory purchases, equipment upgrades, or to cover temporary cash flow shortages.

Revolving vs. Non-Revolving Lines of Credit

In addition to being secured or unsecured, credit lines can also be classified as revolving or non-revolving.

Revolving lines of credit

Revolving lines of credit typically allow the flexibility to borrow, repay, and borrow again up to your approved credit limit, as long as you make timely payments. With these structures, such as HELOCs and credit cards, the key feature is the ability to manage your balance dynamically. If you repay the total borrowed amount by the due date, usually, no interest is charged. However, if you opt to carry a balance beyond this date, you could enter a “revolving” phase where interest is applied to that balance. This system gives you the control over how quickly you repay the borrowed amount while requiring minimum payments to keep the account in good standing.

Non-revolving lines of credit

Differing from the revolving types, non-revolving lines of credit can involve a more structured approach to borrowing and repaying. Once you withdraw funds, that amount becomes a fixed-term loan, where you pay back the sum over a predetermined period with a set payment schedule. Each disbursement from your line of credit acts as a separate loan installment, and while the overall account remains open, this could allow for multiple withdrawals as long as the cumulative total does not exceed the total credit limit. This setup ensures that for each amount drawn from the credit line, you have a clear repayment plan, making it easier to manage finances and understand how long it will take to settle the borrowed amount each time.

While the majority of credit lines are either revolving or non-revolving, some banks may have more unique offerings, allowing customers to borrow a lump sum (up to their borrowing limit) without needing to reapply each time.

How to Qualify for a Line of Credit

To qualify for a line of credit, lenders will typically evaluate your creditworthiness based on several factors, which can include:

• Credit score: A higher credit score could indicate a lower risk for lenders and could help you qualify for better terms and rates. Many lenders require a minimum credit score of 610-670 for unsecured lines of credit. Keep in mind, some lenders approve applicants with lower credit scores, but these approvals may come with higher interest rates or stricter terms which may offset the increased risk to the lender. 

• Income: Lenders want to ensure you have a stable income in order to repay the borrowed funds. They may require proof of income, such as pay stubs or tax returns.

• Debt-to-income ratio: This is the amount of debt you have compared to your income. A lower debt-to-income ratio shows that you have sufficient income to cover your existing debts and the new line of credit.

• Current banking relationships: A positive banking relationship could demonstrate reliability and trustworthiness, potentially leading to more favorable terms or easier approval for new credit lines. Banks often consider the breadth and depth of this relationship, including your history of deposits, account balances, and previous loan repayments. 

Secured lines of credit may have more lenient qualification requirements since the collateral could reduce risk for lenders. However, it may still be important to demonstrate your ability to repay borrowed funds.

Advantages of Lines of Credit

Lines of credit offer several advantages over other types of borrowing:

• Flexibility: Once qualified, you can borrow as much or as little as you need up to your credit limit, and you only pay interest on the amount you borrow (or a single flat fee, if offered by your bank).

• Convenience: Once approved, you can usually access funds quickly and easily, often through online transfers, a linked credit card, or a deposit directly into your bank account.

• Lower interest rates: Lines of credit may typically have lower interest rates and fees than credit cards, especially if secured.

• Improved cash flow: Lines of credit could help you manage your cash flow by providing access to funds for a single purchase or investment, without the need to dip into your savings.

Read more: How lines of credit can affect your credit score

Disadvantages and Risks of Lines of Credit

While lines of credit can be a useful financial tool, they also come with some potential drawbacks:

• Variable interest rates: Most lines of credit have variable interest rates, which means your monthly payments could vary if interest rates change.

• Overspending temptation: Easy access to funds can tempt some people to overspend, leading to increased debt. It could be important to stay disciplined and strategic when borrowing money.

• Potential for higher costs: If not managed responsibly, the interest charges on a line of credit could add up quickly, especially if only minimum payments are being made.

• Impact on credit score: Like with any form of borrowing, late payments or high balances can be reported to credit bureaus and negatively impact your score.

5 Tips For Responsible Line of Credit Use

To make the most of a line of credit and avoid potential pitfalls, follow these tips:

1. Borrow only what you need: Just because the funds are available, doesn’t mean you need to use all of them at one time. It can be important to avoid borrowing more than you need.

2. Make timely payments: Pay at least the minimum payment by the due date each month to avoid late fees and potential damage to your credit score.

3. Pay more than the minimum: When possible, you could also pay more than the minimum to reduce your interest charges and pay off your balance faster.

4. Monitor your balance: Also, it may be wise to regularly check your balance and ensure you're not getting close to your credit limit.

5. Have a repayment plan: Before borrowing, have a plan for repaying the funds to avoid getting stuck in a debt cycle.

A New Way to Borrow

Varo Line of Credit¹ provides amounts starting from $600 with the potential to grow up to $2,000 over time. While traditional personal lines of credit accrue recurring interest, we charge a fixed, transparent, and one-time fee based on the borrowed amount, so you know what fees you will be paying up front.

To determine your eligibility, we look at your Varo account activity (deposits, account balances, on-time payments) as well as your credit score. Once approved, you could borrow up to the maximum allowed on your line of credit. You'll repay it in equal monthly payments over the course of an agreed-upon term — from 3 to 12 months, depending on the amount borrowed. Once you have paid back the full amount, you may be able to borrow again.

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.}