A line of credit, also known as a credit line, is an agreement between a bank/financial institution and a borrower to provide access to funds on-demand. Under a line of credit, the borrower can access funds whenever needed (provided the borrowings do not exceed the maximum limit fixed by the lender) and repay them over time.

Most credit lines function as a revolving facility—you can borrow money, spend it, repay the debt to replenish the limit and borrow again in a virtually never-ending cycle.

When you need access to instant liquidity during a financial emergency, having a credit line is incredibly useful. You can tap into it without going through the trouble of applying for a loan. Such credit lines are also available for both personal and business needs.

How does a line of credit work?

line of credit works as a hybrid of a loan and a credit cardThe lender approves a borrowing limit, and you get access to a pool of funds up to a specified limit.

You can keep borrowing in small installments up to that limit, and there is no obligation to draw the entire amount in a single shot. You are also free to use the borrowed amounts to meet any financial need you may have—unlike traditional loans, lenders of credit lines do not monitor the end-use of the cash withdrawn. 

The interest for a line of credit starts to accrue as soon as you borrow any amount. But it is payable only on the funds you have actually borrowed and not the overall loan limit. For example, if your line of credit is INR 5 lakh and you withdraw only INR 50,000, the interest is payable only on INR 50,000.

Every line of credit has a ‘draw period’ and a ‘repayment period.’ Draw period refers to the time that you get to borrow the money. The exact duration of the draw period is specified in the line of credit agreement. You can make minimum monthly payments during the draw period to reduce your debt liability and repay the interest. Some lenders also permit using a part of the payment towards repaying the principal and reset the limit for future borrowing.

When you enter the repayment period, you’re given a period of time within which you need to pay off the entire debt. Once you repay the amount, your credit limit replenishes, and you can dip into it repeatedly to keep borrowing.

The lender gets to decide the maximum credit limit, interest rate, and repayment schedule. These depend on several factors, including your credit history, source of income, and your creditworthiness.

What are the different types of lines of credit available?

There are two types of lines of credits popular in the market: secured and unsecured.

If you opt for a secured line of credit, you need to offer a personal asset as collateral or security. In case you fail to repay the borrowed amounts on time, the lender can seize the collateral and recoup the money advanced. The interest rate of a secured line of credit is comparatively lower than an unsecured one. But the credit limit tends to be higher. 

If a lender sanctions a line of credit to you without asking for any collateral in return, it is known as an unsecured line of credit. Such credit lines are riskier for lenders as there is a considerable risk of no repayment. As a result, the lender charges a higher interest rate and offers a lower credit limit.

Pros and cons of getting a line of credit 

Here’s a snapshot of the benefits and the shortcomings of a line of credit:

Advantages of a line of credit:

  • A line of credit offers you the flexibility of withdrawing money multiple times without making a fresh application each time. Most lenders allow this without imposing any additional charges
  • Once approved, the line of credit stays valid for at least three years
  • The interest rate for a line of credit is cheaper than traditional loans. Moreover, unlike personal and business loans, the interest is also payable only on the amount you actually borrow and not the entire amount sanctioned
  • Most lenders allow you to prepay the borrowed amounts before time without any fees or penalties. 
  • For SMEs, opting for a line of credit is a great way to control the cash flow throughout the year and take care of unexpected short-term funding needs. It also helps you to meet the ever-changing demands of your business in a hyper-competitive market

Also read: 6 Reasons Why a Line of Credit Is Necessary for Every Business

Disadvantages of a line of credit:

  • The flexibility offered itself can be a huge shortcoming, especially if you are not disciplined about managing your finances. If you don’t regularly pay off the borrowed amounts, the interest may pile up
  • If you borrow more than you can repay and fail to clear your debt on time, it can impact your credit score adversely

Are you looking to finance your small business through a line of credit?

Getting a line of credit from a bank can be time-consuming. Razorpay Cash Advance makes it convenient for your business to get instant access to an unsecured line of credit and manage your cash requirements at all times, especially when faced with an unexpected demand.

Here are a few benefits you can enjoy with Razorpay Cash Advance:

  • Withdraw cash up to your credit limit instantly without making a fresh application each time
  • Pay interest only on the withdrawn amount
  • Repay when you receive payments from customers and borrow again when you need funds. You can even repay automatically through daily settlements
  • No need to pay any processing or annual fee

Razorpay’s alternative credit decisioning system also pre-approves you for Cash Advance based on your past customer transactions—so you don’t have to wait forever to get your application approved. 

Don’t let your business suffer due to a lack of funds. Keep borrowing and keep growing!

 

Author

Ashmita Roy is a Content Marketer at Razorpay. When she’s not working, you can find her strumming her guitar or writing poetry. Dislikes writing about herself in third person, but can be convinced to do so via pizza or cheesecakes.

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