A line of credit in its most simplest of terms is an agreement between a lender, such as a bank and a customer (business or personal). The agreement establishes the maximum amount of money the lender is willing to lend to the client. Depending on the type of line of credit there are various risks.
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A line of credit loan only requires a single approval before money can be withdrawn by the borrower. For example, your bank may extend you a line of credit equal to $10,000. Now let's assume you initially take $3000 of that money to build a deck on your home. One month later you require another $3000 for a kitchen renovation job; you simply request the money from your bank using your available line of credit, and the money is deposited into your account. Since you have a $10,000 line of credit, and you've used only part of that money, the rest is still at your disposal.
Unlike fixed loans which you can receive on your mortgage and other loans, these lines of credit are typically revolving in nature. The simple fact for this revolving type of cycle is the fact that borrowers can withdraw money at any given time, while market conditions may have changed and rates may be higher than they were at the time of the initial lines creation.
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Dangers and Risks For Line Of Credit Loans
In most cases, your line of credit will be based off a variable interest rate. If market conditions change, leading to larger interest rates, your loan rate will also increase. A large increase can mean a larger monthly payment amount, which in turn for many families can mean a huge strain on the monthly budget.
The loss of collateral can also occur if payments aren't made on time. The most traditional cases of this occurring are foreclosures in the case of home equity lines of credit. Since you are using your home as collateral, it can be seized if payments are missed. Other collateral can also be seized if payments are not meant. Typically, these are non-recourse loans, meaning the bank will only seize your collateral. However, you'll want to check the contract terms, or you could end up losing your collateral and your shirt.
Forgetting to cancel your line of credit, even when your balance is at $0 can lead to annual fees. Not all lines of credit charge an annual fee for the right to use them, but in same cases they do and even if that loan reaches $0 you may be charged an annual fee if you forget to close the credit line.
Some lines of credit will also require that you keep the line open for a certain period of time and make payments as pre-determined, closing the line of credit early could lead to early termination fees that vary from institution to institution.
Finally, there may be other "various charges." Ror example, the lender may charge a higher interest than standard loans, or they may charge a monthly maintenance fee for "managing" your account, while other use fees could be attached, such as a withdrawal charge, payment fees, and other charges.
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Line of Credit Conclusion
Make sure to read the small print regarding your line of credit. Look for associated fees with using the line of credit, including how rates may change, account management fees and all other extra costs that may be associated with the line of credit.
Shopping around with several vendors is also highly recommended so you can find the lender with the best terms that meet your needs.