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.
#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.
