Intro

What is a Line of Credit and How Does it Compare to Other Products?

A line of credit (LOC) is a facility that is usually tied to a bank account, that allows a borrower the flexibility to use funds in excess of what is contained in the account. E.g. if you have $10,000 in your account and you need to conduct a transaction of $30,000, you could still access the $30,000 if you had a line of credit facility, excepting that the extra $20,000 would be used from your line of credit after the $10,000 is deducted from your bank account. A LOC is defined by the website Investopedia as “a preset borrowing limit that can be used at any time.”  It is a loan that can be accessed whenever you want without having to apply again once it is repaid.

 Usually there is a limit that persons who have this facility are extended e.g. if you are given a $100,000 line of credit, you are allowed to borrow up to $100,000 (over what is in your bank account). After you repay the amount, or if you make a partial payment you are usually allowed to borrow again, as long as the amount that you are in credit for is less than $100,000.

The product works similarly to a credit card, and the associated savings/current account is the vehicle for the credit facility. There are different types of Lines of Credit:

• Personal Line of Credit – Offered to Individuals
• Business Lines of Credit – Offered to Businesses and sometimes it is done through the Point of Sale machines as a special facility
• HELOC (Home Equity Line of Credit) – Offered to property owners to borrow against the equity in their homes. This is a product I have not seen existing in Jamaica, but I may just be unaware, so please comment if you know of any institution that does this.

Lines of Credit can also be secured (by a house or receivables for example) or unsecured. The image below shows some of the differences between the three main unsecured products. The unsecured loan would include payday loans, microloans or other loans not backed by traditional security (cars, houses etc.).

The interest rates for Lines of Credit (unsecured) are higher than rates of an unsecured loan, but lower than rates for a credit card. 

You may be wondering why the interest rate charges are different. The answer is that the risk of each product is reflected in the price one has to pay for it.  Although all three facilities have no security/collateral backing up the loan (i.e. they are all unsecured products), the rate charged for a LOC is a medium between the risk profiles of those two products. Here’s what I mean: 

• An unsecured loan requires a detailed assessment about your ability to repay at a single point in time.The lender makes a reasonable assumption about your debt obligations at the time of issuing the loan and has therefore estimated that they have assessed their risks for this one-time loan so gives a specific interest rate for that loan. This rate will reflect the fact that there is also no collateral for the loan so if you default there is nothing for them to sell to recover their money.

• At the time of writing, BOJ indicates that “Other Unsecured” loans average about 18.45%. My research indicates that personal loans (including payday loans) range from 4.58% to 38% across regulated and unregulated financial institutions.

• A line of credit is only used at certain intervals and generally for an emergency or for unexpected expenses (hence its attractiveness particularly to businesses). Interest only accrues if the account holder accesses the facility. It is typically offered to persons who have good credit and do not need it.[1] The Bank of Jamaica of Jamaica does not report on this facility specifically, but I assume it is rolled up in the “Other Unsecured” loan category if reported at all. The fact that the person has access to the facility without having to go through underwriting each time (i.e. assessed for their ability to repay) means it is riskier than an unsecured loan so the interest is usually higher. The rates I observed from the companies who offer it here range from $100 per day to 15 – 20.75%. This isn’t much higher than an unsecured loan, but it is usually higher for the companies who offer both.

• Similarly, a credit card can be used at any time and as such the lender can never be sure about repayment, especially months/years down the line. It is a continuous unsecured facility for which the account holder can experience a significant change in income (lost their job) or expenses (may max out the card every month) and the financial institution doesn’t have an opportunity to conduct any additional underwriting after the card is issued to the borrower excepting the spending habits related to the card. A credit card is therefore the riskiest of the three options, so card interest rates would be highest rate of interest in any credit market. At the time of writing the BOJ Credit Conditions Survey[2] indicates that the average rates for credit cards is 40.05%.

The graph below shows the rates for credit cards, unsecured loans and a secured loan- a mortgage. 

Upon investigation there were few banks that indicated on their sites that they offered personal lines of credit (JN Bank and Scotia) as most of the others only had business lines of credit.

The application process for a line of credit differs by financial institution but in general the following will likely be required:

• Proof of address
• Proof of employment
• ID/ TRN
• Payslips
• Credit Report

 Advantages of a Line of Credit:

• Only pay if you use it
• More control over your spending and use (less impulse spending) than a credit card
• Typically lower interest rate than credit cards
• More flexibility than an unsecured loan
• You have access to funds if you need it, without applying for a loan each time
• Ideal for a long term project where expenses are variable, or for emergency expenses

Disadvantages of a Line of Credit:

• Typically higher interest rate than an unsecured loan
• No benefits like rewards or cash back
• Does not have protections similar to credit cards (fraud protections etc.)
• Can accrue large interest charges if not paid back in a timely manner
• If you do not make the required payments, your credit score could be negatively affected

Using a Line of Credit Responsibly

• Only use it for emergencies. The LOC should not be in a permanent usage because you will be paying for it each day that you have used it, even if you have only used a portion of your total limit.  

• Pay back the amount you borrow in full as soon as possible. The less interest you pay the better. Interest is accrued per day when you have accessed the facility, so pay it back as quickly as possible to avoid excess charges.Once you put money in the account that is tied to the LOC, the bank may actually just put it towards the loan amount.

• Do not use it for the purchase of an asset like a house or car. Mortgages and car loans have much lower rates than a line of credit, so don’t use it for the purchase of assets that can be used as a security for a loan with a lower interest rate. Even if its an asset like a fridge or stove, an unsecured loan may be better than a line of credit.

• Do not use it for debt consolidation. Again this is a higher interest rate facility. It would be better to consolidate debt at the lowest rate possible.

If you are thinking of getting a credit facility, I hope this helps in your decision about which one to think about. Visit my article on Credit Cards in Jamaica including tips on using them responsibly to maximize the benefits and also visit my article on Reducing Balance vs Add-On to guide you on shopping for an Unsecured Loan. 

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[1] https://www.ratesupermarket.ca/blog/do-you-need-that-personal-line-of-credit/

[2] http://boj.org.jm/publications/publications_show.php?publication_id=20