A line of credit is a banking service that allows you to use the bank’s money within a certain amount for any period of time. This service is provided mainly to legal entities and government agencies. But also to individuals, when they issue a credit card (with or without a grace period), in fact, they open a line of credit. However, in banking services, this term is used in relation to organizations.
A credit line differs from a standard bank loan in that funds can be used in installments as needed. For example, a bank provides a credit line (CL) of $100,000 for a calendar year. The borrower takes this money from the bank in installments – tranches (for example, $25 million per quarter), also periodically paying them back.
This is convenient for those who periodically require large cash infusions to finance investment programs, replenish working capital, and liquidate the budget deficit. A credit line in such cases allows you not to issue a new loan every time with the accompanying collection of a package of documents, waiting for bank approval, etc.
The line differs from the targeted loan in that the money can be spent on anything.
Who uses credit lines?
There are two categories of people using these loan products.
Legal entities
Private companies open a line of credit to finance their investment projects or to replenish working capital and cover the cash gap. The firm must pay salaries to staff strictly on the 10th and 25th of each month, for example. The transactions from the goods’ sale are received unevenly – sometimes buyers delay payment for a month or two. And so that employees do not sit without money, the company opens a credit line: at the right time, it can borrow from the bank as much money as is needed to pay salaries.
State or municipal organizations. If you type “line of credit” in the search bar of the public procurement portal, you will get a long list of requests for lines of credit. Unlike private companies, there is no freedom of choice. The loan terms are clearly stipulated in the terms of reference, and any bank suitable for the customer’s requirements has the opportunity to become a lender.
Individuals
Any individual can be eligible to open a credit line (usually in the form of a credit card). Any person, like an organization, may have situations when the money has run out, it is still a week before the paycheck, and you want to buy some foods. Credit cards are released to help a person in such a situation.
The bank sets a credit limit, for example, $100. You can use this money at any time and in any proportion, for example, pay for groceries in the store, then a few days later refuel at the gas station. In a week, buy a laptop.
Almost all credit cards have a grace period, which allows you to use the bank’s money without charging interest, that is, free of charge.
If you do not have time to repay the debt during the grace period, you will have to pay interest to the bank for each month of using the loan funds. The interest rate is usually higher than for cash consumer loans. Therefore, it is beneficial to use credit cards, keeping within the grace period.
Many credit cards are credited with cashback for completed transactions, which allows you to save on purchases, usually 1-10%. It is especially beneficial to use credit cards in combination with profitable debit cards.
To prevent the credit line from being blocked, part of the debt must be paid back once a month. Accordingly, the credit limit will be restored by the amount deposited.
Types of credit lines
The banks provide several types of credit lines, depending on the terms and methods of using the funds. Further, we will consider the types of credit lines created only for legal entities.
Framework credit line
The bank provides an amount to pay for the supply of goods under a specific contract within a certain period. The funds can be spent only for those purposes that are indicated in the text of the agreement: if the project involves the purchase of a large number of office equipment, the development and installation of special software and nothing else, then you cannot use the funds received from the bank, for example, to buy a car for the company. The framework for the use of money is established. Often, such credit lines are used to purchase machinery, equipment or materials within the framework of one or several projects. The framework line is convenient for the bank, since the risks of misuse or cashing and withdrawal of credit funds by the owners of the company are reduced.
Contract account line
By its principle, it is similar to an overdraft: the client can keep his own funds in the account, and in case of a shortage of them, he gets access to the bank’s money. The next own transferral to the account cancel the debt, and the credit limit is restored. The firm has a current bank account of $10 million. The cmpany decides to expand. Managers calculate the necessary funds and estimate that there should be enough money to rent new premises, arrange working space and purchase equipment. But in the process it turns out that extra work is needed for another $3 million, and other additional investments may be needed. The company opened a counter-account credit line for $5 million more. They took 10 million from their own plus 3 credit, then after 2 weeks another million for additional expenses. Having received revenue of 12 million, the company restored working capital and repaid a significant part of the credit line, restoring the credit limit to (5 – 3 – 1 + 2) = $3 million
Call credit line
The bank opens an account, the client takes money from it, and the repayment occurs when the account is replenished (there is no clear repayment date, only a deadline is set, after which the penalties begin). It is analogous to a credit card. This type of credit line allows you to pay interest only for the period when the money is used, and save on the quick return of borrowed funds.
An call line of credit is convenient when you need to cover the cash gap (you know for sure that you will have your own money, but it will come later than the due date for the obligatory payments – it is the loan funds that are taken for them).
Revolving line (revolving credit)
The most common type of credit lines. The maximum amount and maximum term of the loan is set. Within these limits, the borrower can use the funds as many times as specified in the agreement, without extra agreements, and partial or full repayment occurs when the account is replenished. After an intermediate repayment, the credit limit is restored to the amount that was repaid.
Such a loan is called revolving, since restoring the limit can be compared to reloading a weapon. Used for a wide variety of businesses as well as personal use. It is well suited for entrepreneurs whose sales of products are cyclical.
Non-renewable (simple) line of credit
The bank enters into an agreement with the client for the provision of a certain amount, which the borrower can receive in parts (tranches) without signing additional documents. When repayment, in full or in part, the credit limit is not restored.
As soon as the entire amount is repaid, the relationship between the parties ends. Such lines of credit are often used by businesses to purchase equipment lines when a certain amount is required (no additional investment is needed), but payment is made in installments. Government agencies or authorities open such lines to finance one-time government contracts at the beginning of the year or in the periods between major tax revenues.
Benefits of credit lines
There are several advantages that credit lines distinguish:
- ease of loan use: money can be borrowed in parts, and there is no need to sign separate agreements each time;
- the size of each loan is determined by the client himself – within the bank limit;
- the method of getting funds is agreed individually – you can choose the type of credit line;
- interest is paid only for the actual time of using the money (unlike a loan for which you pay interest in full, even if you used only a small part of the amount);
- the interest rate for lines of credit is usually lower than for a regular loan.
Cons of credit lines
There are few disadvantages of this lending type. They are usually initially prescribed in the agreement. This may be an insufficient limit for the issuance of funds – for example, even if there is $100 million on the account, the borrower has the right to take no more than 80 million at a time. Sometimes this is a short term of the line, but the borrower agrees with it when signing the contract.
But from the point of view of the payment terms for legal entities, there are several disadvantages in comparison with a regular loan:
- the application is considered longer – since we are usually talking about the allocation of a large amount, albeit extended in time, the bank more carefully checks the financial state of the borrower and his prospects;
- the borrower must comply with the terms of the agreement as carefully as possible – with the slightest delay, the next tranche will not be paid;
- the client must inform the bank about changes to the statutory documents (for example, about the emergence of new areas of activity, about the change in the founders, and so on);
- fines may be imposed for not using the credit line in full.