When financial disaster strikes and your savings are low, a personal line of credit (LoC) may be the answer. It’s a common way to handle emergencies when you’re low on funds and facing an unexpected expense — whether it’s an unanticipated trip to the vet or the mechanic.
But before you sign along the dotted line, it’s important you understand what you’re getting into. Even the best line of credit may be unaffordable if you don’t understand your obligations.
If you want to make sure your LoC is the right fit, ask yourself these three questions before you apply.
#1. Is it What You Really Need?
In an emergency, choosing the right product for your finances can help you manage your expenses. And when it comes to your choices, an LoC is just one of them.
Before you lock into anything, it’s a good idea to look over your options. Is an LoC the right choice for you, or is a personal loan more up your alley?
You’re probably familiar with the personal loan as a concept. Nearly everyone takes out a loan at some point in their life — whether it’s to pay for school, a home, or a major household purchase.
A loan is money you borrow from a financial institution, just like an LoC, so when would you choose one over the other?
To answer that question, we first have to compare the typical personal line of credit vs personal loan options.
How is a Line of Credit Different from a Loan?
The major difference between loan and line of credit products is how you access your cash.
With a loan, you’ll receive your cash as one lump sum. Interest starts accruing on your full balance as soon as you receive it, and you’ll be responsible for paying it all back by a specific date — either in one lump sum or over scheduled installments.
Once you pay it back, you’re done. The only way you can access more cash is by reapplying.
An LoC operates a little differently. Instead of receiving cash in one lump sum, you get a personal line of credit limit that you may use and repay on a repeating basis.
This limit defines the maximum amount of money you may borrow at any given time but not the minimum; you may use as much or as little of this limit as you need.
Interest only starts accruing on the portion that you use and not the total limit. Once you pay off what you’ve used, you’ll still have access to your limit without having to reapply.
Which One Should You Choose?
The revolving nature of an LoC is one of its greatest advantages. It saves you the trouble of having to reapply if a bill or repair ends up costing you more than you expect.
Nevertheless, having access to this limit can be too tempting to ignore, which may lead you to tap into your line for non-essential items.
You’ll need to weigh the pros and cons carefully to see which one suits your emergency best.
#2. What is Your Credit Score?
Once you’re ready to move ahead with an LoC, it’s time to apply. While you can fill out as many applications as time allows, you may not be approved for each one you submit.
Why? Your credit score plays a huge role in the products you can qualify for.
This score is a three-digit number that many financial institutions look at before they approve your request for funds.
Checking your score helps financial institutions determine the following two things:
- Whether they will approve your request or deny it.
- What rates, terms, and conditions to apply to the LoC they grant you.
What Score Do You Want?
According to the two most popular scoring ranges FICO and VantageScore, your score may fall anywhere between 300 and 850.
If you want the most options, set your sights on 850. Generally, the higher your score is, the better.
Unfortunately, the chances that you manage to get this score is iffy, as just 1.2 percent of consumers have it. For the rest of us, a more important division of scores is between prime vs subprime.
Generally, a prime score (700 and above) will open financial doors. Not only will you find it easier to be approved, but you’ll receive more flexible or affordable rates when you do.
A subprime score (699 or below) may complicate getting the funding you need, but some financial institutions may extend line of credit loans for people with bad credit.
Why Knowing Your Score Helps?
In an emergency, you need money fast, full stop.
Applying for a product that you don’t qualify for tags on extra time you may not have.
Knowing your score helps you narrow down your options. You’ll know which products to skip, and which ones you’ll more likely to qualify for.
To learn more about your score — and your broader credit report — click here. You have three free checks each year.
#3. Can I Afford It?
Last, but definitely not least, is the question of affordability. It’s easy to overlook in an emergency.
The problem is, a disaster tends to give you tunnel vision.
You’re so focused on solving the immediate problem that you don’t take into account future ones you might cause by taking out a personal line of credit.
Sitting down with your budget will help you decide if your LoC is a practical option for finances.
A Budget Helps You Crunch the Numbers
Some people will know this right off the bat. Others will need a budget to see if they earn enough money to take on LoC repayments on top of their regular bills.
There are a lot of different budgeting techniques out there, but what they all boil down to is this simple equation:
Your income – Your Expenses = Leftover Cash
Once you punch in the numbers, do you have enough leftover cash for your repayments?
There’s no need to panic just yet if there isn’t enough.
Ultimately, your budget is all about creating balance. If you expect to cover your repayments, you’ll need to scale back on fun things to afford them.
Look at your list of expenses again and divide them into needs and wants — needs being anything you must pay for your safety or comfort, while wants are fun things you can live without.
Target these wants for savings. If you can slash some of them from your budget, you’ll free up cash to go towards your repayments.
Fools Rush In
In an emergency, finding the quickest LoC possible may be your first thought. It would help you cover an unexpected bill without delay, after all. But you might rush into something that doesn’t fit.
By slowing down to ask these important questions, you’ll do more good than acting fast could ever do.
Remember this the next time you face down a financial emergency. Your answers may help you find a more affordable way to pay your bills.