Line Of Credit - LOC

Categories: Credit

A type of open-ended credit that lets you withdraw and borrow money as often as you'd like—up to a certain limit.

In some cases, people use their homes as collateral. Lines of credit usually have low interest rates and are very flexible. You could keep withdrawing money out of them as long as you still have money left in 'em.

Example:

You finally paid off your house and now you have a $200,000 house, mortgage-free. You decide to open a $20,000 line of credit so that you have money for a rainy day, or for fixing up the house.

With your line of credit, you can take out $20, $200, or anything at all up to $20,000. If you pay it back, you can take out more money—again, up to $20,000. There's an interest amount you pay, but only if you withdraw.

Let's say you take out $10,000 to fix your windows. The bank may determine that you owe $200 in interest on that amount. They automatically take the $200 out of your account each month until you pay back the $10,000. Once you've got your house spruced up, you can focus on repaying the $10,000, or you can keep withdrawing money until you hit $20,000.

“Oh, I’ll definitely pay it back.” Yeah, that’s a line of credit. But it’s just...a line. Like, “Can I buy you a drink?” or “Do you come here often?” or “I bet my mother would love you.”

In financial real life, a line of credit...or LOC, if you just like using acronyms to make yourself seem arcanely smart...is debt. Or rather, an LOC is an option to take on debt.

Why would somebody want an option to take on debt?

Here’s why. Companies can’t ordain their futures. They don’t know what’s coming. But paying a few bucks today for “financial life insurance” tomorrow is usually a really good idea, because the skies are not always sunny all day. So a company that makes shoelace-tying robots might be doing great today, but there’s a big fat product release coming, and they have no idea if it’ll do well right away or take three years to catch on. Who knows? Maybe people will actually be able to tie their own shoelaces by then.

But yeah...it’s unpredictable. This sort of thing happens to tech companies all the time. While the company doesn’t need cash today, they may need it in the future. So they pay a bank or lender a small token amount in return for that lender guaranteeing that the money will be there at a set price in rent and set terms at some point in a defined future...the next three years, or something like that.

If a company does, in fact, decide to exercise its option to draw down cash from its line of credit, or rather, to get the bank to wire the cash they've reserved into the company’s own bank account, then usually it just starts paying interest (or rent) on the money it’s borrowed, like it would have had it borrowed money at the outset.

Why wouldn’t a company just borrow money today and have it stuffed under its mattress? Well, because (almost always) the option to draw down money costs a fraction of the interest it would cost to borrow the money itself. So...we have a company that wants the right to borrow 10 million bucks...and they're willing to pay half a percent a year for a guarantee to be able to borrow that money at, say, 5% per year when or if they do borrow it. The half-a-percent line of credit option fee is 50 grand a year...and let’s say 2 years go by and the company doesn’t need the money—but then they borrow all of it in year 3.

So the company paid 100 grand for the option to borrow the money at 5% interest...and yes, that 100 grand is a lot of dough, but compare it to the cost of borrowing, had the company borrowed all 10 million right away. They would have paid 5% per year in interest on that 10 million bucks, or 500 grand a year...and that’s times 2 years. So it would have cost them a million dollars in interest had they borrowed all the money right away.

Instead, they only paid 100 grand for the option for 2 years, because they didn’t need the money right away…and that “line of credit structure” saved them 900 grand in borrowing costs.

So why isn’t it free to just reserve a line of credit with a bank? Like...why do they charge anything when they’re not actually loaning out money today?

Well, the bank has to allocate its finite resources to accommodate that line of credit draw down. Sure enough...Murphy’s Law at work. The company will want to exercise the LOC...and draw down the money at just the worst time for the bank.

Banks have tightly regulated laws, or covenants, around which they can borrow money from the Fed at, say, 2%, then market it up to 4% and...lend it out. So if the bank had tons of LOCs out there...could be bad news if they weren’t charging a little something for them.

And note: a credit card essentially is a line of credit. You fill out a bunch of forms, then swear and pinky swear to pay back the money. If a month goes by and you don't pay back the money you owe, you get charged enormous rates for borrowing it.

But if you do pay it back, the rates are really low. Maybe you have a small annual fee, although most credit cards don’t have those anymore. But more directly, the “fee” is paid by the merchant, i.e. the earring store that sold you 7 belly button rings for 40 bucks each in the form of a transaction fee. That is, for the $280 you spent to have a constellation on your stomach, the merchant paid the credit card company about 1%...or $2.80 for managing the bank in that transaction.

Or...about as much as you’re going to be spending on cotton swabs and antibacterial soap. Hope you weren’t planning on wearing a tube top any time soon.

Related or Semi-related Video

Finance: What is a Line of Credit?133 Views

00:00

finance a la shmoop what is a line of credit? oh I'll definitely pay it back. [ man talks to camera]

00:08

yeah, that's a line of credit, but it's just a line like can I buy you a drink

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or do you come here often or I bet my mother would love you, in financial real

00:19

life a line of credit or LOC if you just like using acronyms to make yourself

00:23

seem are keenly smart, is deb,t or rather an LOC is an option to take on debt. why [man in front of power point]

00:30

would somebody want an option to take on debt? well here's why.

00:34

yep companies can't ordain their futures. they don't know what's coming .but paying

00:38

a few bucks today for financial life insurance tomorrow is usually a really

00:42

good idea because the skies are not always sunny all day. so a company that [robot assembly line]

00:47

makes shoelace tying robots might be doing great today but there's a big fat

00:52

product release coming and they have no idea if it'll do well right away or take

00:57

three years to catch on. or you know rip people's feet off well who knows, maybe

01:03

people will actually be able to tie their own shoelaces by then. what do you

01:06

think America? how are we doing but yeah it's unpredictable this sort of thing [man sits on a couch]

01:11

happens to tech companies all the time. so while the company doesn't need cash

01:15

today they may need it in the future .so they pay a bank or lender a small token

01:20

amount in return for that lender guaranteeing that the money will be

01:24

there at a set price in rent and set terms at some point in a defined future.

01:29

ie the next three years or something like that. that is, you know prevailing

01:33

rates or five percent they might pay half a percent to guarantee they can

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borrow it 10 million dollars at 5% but, we'll get into. that all right if a [smiling man on the phone]

01:40

company does in fact decide to exercise its option to draw down cash from its

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line of credit or rather to get the bank to wire the cash they have reserved into

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the company's own bank account then usually it just starts paying interest

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or rent on the money the day it's borrowed, just like it would have if it

01:55

borrowed money at the outset. well why wouldn't a company just borrow money

01:59

today and have it stuffed under its mattresses? [woman holds a stash of cash]

02:02

well because almost always the option to draw down money costs a fraction of the

02:07

interest it would cost to actually borrow the money itself. so we have a

02:12

company who wants the right to borrow ten million bucks and

02:15

they're willing to pay half a percent per year for a guarantee to be able to

02:20

borrow that money I'd say five percent per year when or if they borrow it. if

02:25

they never borrow it that half a percentage is wasted. [definitions on the screen]

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well the half a percent line of credit option fee is 50 grand a year and let's

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say two years go by in the company doesn't need the money.

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they've just wasted that fifty grand a year each year. but then they borrow all

02:39

of it in year three and guess what in those three years interest rates went up

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two percent 3 percent four percent something like. that yeah it could happen.

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so the company paid 100 grand for the option to borrow the money at five [equations ]

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percent interest, and yes that hundred grand is a lot of dough ,but compare it

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with the cost of borrowing had the company borrowed all ten million right

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away. well had they done that they would have paid five percent per year in

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interest on that ten million bucks or five hundred grand a year and that's

03:06

times two years .so it would have cost them a million dollars in interest had

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they borrowed all the money right away. instead miserly wiserly, they only [man scribbles with a pen]

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paid a hundred grand for the option for two years because they didn't need the

03:19

money right away and that line of credit structure saved them nine hundred

03:23

thousand dollars in borrowing costs. a nice job mr. CFO. so why isn't it free to [thumbs up]

03:29

just reserve a line of credit with a bank? like why do they charge anything

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when they're not actually loaning out money today? well the bank has to

03:37

allocate gets finite resources to accommodate that line of credit drawdown.

03:41

sure enough Murphy's Law happens at work and the company will want to exercise

03:45

the LOC and draw down the money from the bank at just the worst time in history [woman frowns in front of a bank vault]

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like say in the middle of 2008 or 9, when nobody had anything right. okay.

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well banks have tightly regulated laws or covenants around which they can

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borrow money from the Fed or the government at say 2%, then mark it up to

04:05

4% and lend it out. and they make money on that spread right? so if the bank had

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tons of LOCs out there it could be bad news if they weren't charging a little [hands reach for cash]

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something for them. and no a credit card essentially is a line of credit you fill

04:20

out a bunch of forms swear and then pinkie swear to pay back the money .if a

04:25

month goes by and you don't pay back the money you owe well then you

04:29

get charged enormous rates for borrowing. it but if you do pay it back, the rates

04:33

are really low maybe you have a small annual fee although most credit cards,

04:37

they don't even have those anymore. but more directly, the fee is paid by the merchant

04:41

ie the earring store that sold you the seven belly button rings for forty bucks. [ pierced and tattooed woman holds document]

04:45

each in the form of a transaction fee that is, the $280 you would have spent on

04:50

a constellation for your stomach, the merchant paid the credit card company

04:54

about 1% or 280 for managing the bank in that transaction. what about as much as

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you're gonna be spending on cotton swabs and antibacterial soa.p I hope you

05:04

weren't planning on wearing a tube top anytime soon. anyway that's a line of

05:08

credit .use it wisely. it can bite you [woman with red stomach grimaces]

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