If you’ve ever found yourself needing a little bit of extra cash on hand, you wouldn’t be the only one. When it comes to how you actually go about getting this money, there are a few options out there. You could look into things like personal loans, credit cards, or even the generosity of family and friends.
Another potential option that you might consider is a personal line of credit. But what is a line of credit and how will it affect your finances moving forward?
One of the key things you’re going to need to understand is how a line of credit could affect your credit score. This is an important three-digit number that represents your creditworthiness.
What is a Personal Line of Credit?
Just like a credit card, a line of credit is a type of revolving credit. This means that if you’re approved for one, a lender will give you a credit limit that you can draw money from when you need it.
Like a credit card, you’ll pay back the money you’ve borrowed with any interest and/or fees over time. The credit limit you’re offered can be affected by your credit score and certain other factors.
What are the Effects of a Line of Credit on your Credit Score?
Before getting into the specifics, it’s important to point out that in most cases, your payments (and any missed payments) you make on your line of credit are generally reported to a credit bureau. These are the organizations that track your credit score and generate a credit report. The three major credit bureaus are TransUnion, Equifax, and Experian.
Your line of credit is also going to affect your credit utilization ratio. This number shows how much credit you’re currently using from all of your revolving credit accounts. These accounts come in the form of different kinds of lines of credit or credit cards. We’ll break this concept down in more detail later.
Both of these concepts are going to be important to understand moving forward. Now, let’s get into some of the ways in which a personal line of credit can affect your credit score.
1. Your Payment History
Like we mentioned, payment history is a big factor when it comes to your credit history, as it accounts for 35% of your FICO score, which is a credit scoring model. Because the payments you make on your line of credit are likely to be reported to a credit bureau, making these payments on time can have an impact on your score. Conversely, missing payments can also have an impact. That’s why it’s so important to make sure you’ll be able to pay off what you borrow before you use your line of credit.
2. Your Available Credit
Like we mentioned before, the amount of available credit you have can also have a big impact on your credit score. This makes up 30% of your FICO score. Because of this, your credit utilization ratio is an important number to have on hand to see where you stand on this front.
To calculate it, all you need to do is add up the credit limits of all your revolving credit accounts, then add up how much you’ve used across these accounts. Divide the total of how much you’ve used by your total credit limit and multiply this number by 100. It sounds confusing, but lets look at an example. It’ll look something like this:
Example
Let’s say your only revolving credit accounts are a credit card with a limit of $2,000, and a personal line of credit with a limit of $3,000. You’ve used $500 on each account that you haven’t paid back yet, bringing your total use to $1,000, and your credit limit across both accounts to $5,000. The calculation would look like this: $1,000 ÷ $5,000 × 100 = 20.
Here you can see that your credit utilization ratio would be 20%. In general, it’s recommended to keep this number under 30%.
3. Length of Credit History
Another important part of your credit score is the age of all your different credit accounts. In general, the older the account, the more impact it may have on your credit score. So, if you have a personal line of credit that you continue to use and pay off on time, the age of this account may affect your credit score.
4. Credit Inquiries
When you apply for a line of credit or loan of any kind, in most cases, an inquiry will be made into your credit report. This just means that the company doing the inquiry, like a lender, will review your credit reports.
Credit inquiries generally take the form of a hard pull or soft pull. When a hard pull (also called a hard inquiry) is performed, your credit score will usually take a little bit of a hit. This means that if you apply for a line of credit and the lender does a hard pull, your credit score may drop a few points. For this reason, you may want to avoid applying for new credit accounts on a frequent basis.
Soft pulls on the other hand will not affect your credit score. They’re generally done for background checks and a few other things.
Should I Consider a Line of Credit?
You don’t want to apply for a line of credit for the wrong reasons, but they can definitely be useful in a pinch. For example, if you’re dealing with an emergency expense, a personal line of credit can be a useful safety net to help you take care of the short-term cost if you don’t have enough savings on hand.
Just remember that you always need to make sure you can afford to pay off your debt before applying for credit. Take a look at your budget, assess your financial standing, and look for what’s out there. Take your time looking at different types of lines of credit and find something that suits your situation.
Disclaimer: This article provides general information only and does not constitute financial, legal or other professional advice. For full details, see CreditFresh’s Terms of Use.
