Credit Line Considerations

By Kristen Castillo

January 13, 2014 5 min read

If you need cash to fund a significant project such as home repair or advancement in education, a line of credit could be a sound investment. With good credit, you can get a sizable amount of money from a bank or other financial institution.

You need to decide between a personal line of credit, which has a fixed maximum that is available to the borrower to be used like a credit card at any time, and a home equity line of credit, which is a revolving credit line, backed by the equity a borrower has in a fixed asset such as a home. Lines of credit are often renewed automatically.

"The amount of money taken on a line of credit can vary dramatically -- from a $1,000 student loan to hundreds of thousands of dollars on a home," says certified financial planner Christina Povenmire, a fee-only financial planner who owns CMP Financial Planning. "In general, a home equity line can be up to 80 percent of the value of the home."

*Now or Later?

The big question: Should you pay off the line of credit right away, or is it beneficial to pay it over time?

"In order to determine whether you should pay it off right away or over time, you need to look at the cost of capital versus the financial benefits of what you're doing with the cash, forecast overall expected cash flows, and consider future credit needs," says certified public accountant Jaime Campbell, the chief financial officer at Tier One Services.

Many financial experts suggest keeping lines of credit open by carrying a small balance. The theory? Sort of a "use it or lose it" strategy.

"Do not pay the line of credit down to zero dollars, because it might be closed, and the next time that you need short-term cash, the line of credit will not be available," says small-business adviser Joe Geiger.

"Therefore, the credit line should be paid down to a nominal amount, $100 or $1,000 depending on how large the credit limit is, and held at that point. If the line of credit has an interest rate of 6 percent, then the cost of keeping the line of credit open is only $6 or $60 per year, which is a very acceptable amount for the flexibility that a line of credit offers."

*Pros and Cons

The best thing about a line of credit is having the money to pay for what you want. Another bonus? Interest on a home equity line is tax-deductible.

"There are few negatives to a line of credit other than the danger of allowing debt and interest to negatively impact a person's financial life," says Geiger, author of "Entrepreneurial Success, 101 Business Principles, The Road to the Top."

Having so much available cash can make spending too easy. Another disadvantage is paying a one-time origination fee to open a line of credit.

Plus, some lines of credit require more than minimum payments.

"Some lines of credit have terms indicating that they need to be paid in full at least once annually," says Campbell, who explains that the deal could be problematic "if it will take more than a year to get a return on the investment made with the cash."

*Credit Concerns

A big concern is how having a line of credit will impact your credit report. If you handle the financial responsibility well and make on-time payments, you will "probably be viewed as a good credit risk," says Geiger, noting that "lines of credit don't have a hard due date in the same way that car or home loans have."

He explains that maintaining a balance on a line of credit is a lot like having a mortgage. Keep making your monthly payments, and you'll protect your credit score.

Povenmire stresses, "What's more important than the amount of debt or credit is the ratio between how much credit you have and how much you are using."

She explains that using most or all of your line of credit will "probably initially lower your score, but if you continue to pay it off, it can ultimately raise your credit score."

While paying the debt quickly will help your credit score, she cautions consumers to watch for penalties and "other disadvantages to paying it off early."

When to pay off a line of credit is a personal decision, but it may make sense to spread payments over time.

"If paying it off right away means you can't contribute to your 401(k), especially if you're in a higher tax bracket, spread it out over time," says Povenmire, noting that the payments should be at a "reasonable rate -- substantially less than 8 percent."

However, if your 401(k) contributions aren't a problem, Povenmire says, "Pay it off as soon as economically feasible!"

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