Line Of Credit - LOC

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.