A line of credit is a financial product.
Line is a term that comes from the Latin word linea (which can be translated as cord), in turn derived from linum (which refers to flax). The concept has almost thirty meanings in the dictionary of the Royal Spanish Academy ( RAE ).
The first meaning mentioned by the RAE refers to a continuous succession of points. In any case, the notion can also name a series of people or elements; an orientation or tendency; a limit; or a species or class .
Credit , meanwhile, comes from the Latin credĭtum . This is the name given to the money that an entity or individual grants as a loan , establishing under what conditions the amount in question must be returned.
What is a line of credit
A line of credit is a financial product that is similar to a loan but has certain differences. While in the loan the money is received at the beginning, in the line of credit the client can use it according to their needs at any given time.
That is why a line of credit is usually defined as a facility that is granted to a person, a company , an institution or a government. Thus, as funds are needed, they turn to the bank .
It is important to mention that interest is paid based on the money that is actually withdrawn. Therefore, they are not applied to the total figure that is available.
In the case of a loan, however, the lender provides a certain amount of money at the beginning of the operation. The agreement implies that the client must return that sum plus the established interest within a certain time.
With a line of credit, the client has a certain sum at their disposal.
Advantages and disadvantages
The possibility of requesting money according to needs is the main advantage of the line of credit, which can also be renewed after expiration . Interest, as we already indicated, is only paid on what is withdrawn and not on the total.
Typically, the line of credit is used to cover liquidity . Compared to loans, their interests are higher.
Another negative aspect of the line of credit is that the term is usually shorter than the loan. To acquire a high-value asset, therefore, it is not convenient.
The choice of one or another type of credit, in short, must be made based on the destination that will be given to the money. There is no one option that is intrinsically better than the other.
Example of line of credit
Suppose that an SME has a line of credit of 100,000 pesos per month in a bank. This line includes interest of 5% on the money disbursed.
If in a certain month the company requests 20,000 pesos , it must return 21,000 pesos within the corresponding period. This is because, to the 20,000 pesos you receive, you have to add 5% interest ( 1,000 pesos ).
When the line of credit is automatically renewed month by month, at the end of each period the client has the figure again. However, these amounts are not cumulative: that is, they do not add up.