What is a Line of Credit and How Does it Work?

Real estate investing isn’t an easy business to get into. The main thing you’ll face whether you’re investing in your 1st, 10th, or 50th property is coming up with the cash necessary to close and flip for a profit. Even if you have the money, you may still want to find ways to fund your deals without dipping into your bank account. Usually, investors will get a hard money loan, and then find another source of gap financing without having to use their own cash. One of the most popular ways to do this is with a line of credit. What is a Line of Credit and How Does it Work?

A line of credit (“LOC”) is a revolving line of credit issued by a lender. Like traditional loans, it has a limit amount, accrues interest, and requires timely payments. Unlike conventional loans, you can draw parts of it instead of the full amount. Also, lines of credit only accrue interest on the amount drawn from it and have no fixed end date.

Curious to know more? Let’s talk about the different lines of credit available, the different things you’ll need to be approved for a LOC, plus my favorite way to leverage a line of credit for my business.

What is a Line of Credit and How Does it Work?

Lines of credit can be made available for both personal and business accounts. There are two categories for lines of credit: secured and unsecured.

Secured lines of credit are guaranteed by an asset called “collateral.” This is often against the equity owned in your home. Consequently, to be approved for a line of credit with a bank, you’ll need to have some equity to borrow against. Even then, a bank will rarely approve you for your full equity amount as they want to be protected in case something should happen. Since secured LOCs are backed up by collateral, they usually have higher credit limits and lower interest rates than unsecured.

Unsecured lines of credit are run just like credit cards. If you want to break it down to brass tacks, credit cards are considered unsecured lines of credit. These LOCs are not backed up by collateral, so it won’t matter how much equity or assets you own. However, unsecured lines usually offer lower amounts of credit and will have higher interest rates than secured. 

Is a Loan the Same as a Line of Credit?

The reason so many investors opt for lines of credit instead of loans is flexibility. Let’s say, for example, that you’re a real estate investor looking who needs $10,000 now and will probably need another $50,000 later.

With a loan, you’d be required to either get a loan for $10,000 now, pay it off, then go through the whole process (credit checks, applications, etc.) again for the next $50,000 loan. Your interest rate or terms could change between the two loans. 

Lines of credit have much more wiggle room than a loan. You could apply for a $60,000 (or more) line of credit and either shoot for unsecured or back it up with collateral as a secured LOC. If approved, you could pull out that $10,000 now and have interest drawn against only that’s $10,000. You’d still have that extra $50k sitting there available, not accruing interest or needing to be paid back. With each payment, you then free up more of that $60k and can continue drawing from and paying back as long as you have the LOC open.

So if you’re completely, 100% sure you only need a one-time cash infusion, then consider going with a loan. If, however, you want access to a revolving cash infusion for the lifespan of your “loan,” then a line of credit would be the best way to go.

Should I Get a Credit Card or a Line of Credit?

While credit cards are technically lines of credit, they’re not the only line of credit available.

If you get a line of credit from a bank, you’ll draw from that LOC and have liquid cash deposited into your bank account. With a credit card, while you’ll have credit available unless you do a cash advance, there isn’t any money being made readily available. You’ll need to either use the credit card at a vendor who accepts credit cards or draw against it as a cash advance.

Cash advances on credit cards come with their own interest rates, which are often higher than your standard purchase rate. Credit card companies will rarely make your entire credit limit available for a cash advance, too, so you’ll need to consider how much money you need.

It also depends on the reason you need a cash infusion. A credit card with good benefits like cash back or rewards points will be a better asset if it’s for things like repairs, tools, or supplies. Look up “churning” for more details on how these rewards can be leveraged.

If, however, you need money for closing costs or wire transfers to a title company, a line of credit would be better. That way, you’ll have faster access to cash at the interest rate you expect. 

What Can You Do with a Line of Credit?

So now that we’ve covered the boring definitions of what a LOC is and isn’t, let’s talk about how you can use it.

First, let me say that just because you have this money available doesn’t mean it should be spent impulsively. Lines of credit still come with interest rates and require repayment, so taking the family to Disney on a LOC is not prudent. 

Personally, I prefer using secured lines of credit due to the credit limits and interest rates. Like credit cards, if you shop around, you can usually find LOCs with 0% APR introductory rates, making life so much easier.

I use lines of credit to create what’s known as a “spread.” Spreads are the difference between what you owe and what you charge. What am I charging for? The ability for others to use my LOC, of course!

I use lines of credit for hard money lending. If I can find a LOC with a low interest rate and borrow against it for hard money lending, I can then charge a higher interest rate that covers not only my debt obligation but compensates for my time and effort, too.

Final Thoughts

Lines of credit are fantastic tools to use as leverage for real estate investing. Whether you want to use it for your own portfolio or for private lending, having a LOC at your disposal gives you freedom. That said, it’s not free money and shouldn’t be used at whim. If you can find smart ways to use the leverage a line of credit provides, you’ll be able to get further ahead in your business goals much faster than going at it alone.

Have you used a line of credit for your business? Give us your favorite tips in a comment below.

Leave a Comment

Your email address will not be published.