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    Line of Credit vs. Credit Card: Understand These Tools to Optimize Your Finances

    Line of Credit vs. Credit Card

    A line of credit and a credit card are forms of revolving credit. They both allow you to borrow up to a certain limit, with fairly flexible repayment specifications, but they have distinctive terms and conditions. As a business owner, it’s important to understand the nature of these tools in order to optimize your borrowing practices and prudently manage your finances.

    What is a Line of Credit?

    A line of credit is a revolving facility that allows you to borrow money up to a specified limit, with fairly flexible repayment specifications. Establishments may entail an existing banking relationship and an upfront fee. Once established, you can borrow as frequently as you like, but you cannot exceed the approved limit. You only pay interest on the money you borrow, but you may be charged a fee each time you use the line. Unpaid balances simply revolve into the next billing period. 

    A line can be secured or unsecured. A secured line entails the pledging of marketable collateral, such as business equipment or personal assets, like an automobile or home. An unsecured line does not require a security pledge. The distinction is important because secured lines are less risky for lenders. As a result, they generally have better terms (lower interest rates, fixed-rate and variable-rate optionality, and longer terms of availability) than unsecured lines. However, secured lines are much riskier for borrowers, because they put your assets at risk.

    How Does a Line of Credit Work?

    The process of making a draw on a line of credit can vary. Most lending institutions offer a combination of physical and electronic draw options. For those that prefer physical transactions, your loan issuer can give you checks to write. You may also be able to draw funds via in-person or over-the-phone transactions. For those that are comfortable with online banking, you can arrange to electronically execute draws via your personal computer, laptop, or smartphone.

    Most lines of credit are structured to reflect a variable rate of interest, but some financial institutions offer fixed rate products. Regardless of the interest rate structure, most lines are extended for a finite period of time, which is known as the draw period. During the draw period, you can borrow money per the terms of the agreement, but once its ends, you must repay the balance outstanding. Some arrangements call for immediate repayment, while others allow for gradual repayment.

    While the distinction between the draw period and repayment period is clear, it’s important to note that most lines of credit require you to make minimum payments during the draw period. The payments are applied to any interest accrued, but some arrangements allow payments to be applied to both accrued interest and outstanding principal.

    What is a Credit Card?

    A credit card is a type of line of credit that allows you to easily execute in-person, over-the-phone, and online purchases for a wide variety of goods and services. The credit line is connected to a plastic card encrypted with your account information. 

    All credit cards are lines of credit, but not all lines of credit are credit cards.

    Most credit cards are unsecured, and they carry relatively high interest rates. The best credit cards, those with the lowest interest rates and most flexible payment terms, are reserved for borrowers with the highest credit scores. That said, you don't need an exceptional credit score to get a credit card. If you have a decent credit score, good credits cards are out there.

    Incidentally, the interest rate associated with a credit card is usually expressed via an annual percentage rate, which reflects the annualized cost of borrowing.  It is inclusive of nominal interest and fees, but it does not reflect the effect of compounding interest.

    How Does a Credit Card Work?

    Making purchases with a credit card can be done by physically swiping or inserting the card in a terminal; verbally communicating the card’s number, expiration date, and security code over the phone; or entering the card’s number, expiration date, and security code into an online payment form.

    Once a transaction is processed, the purchase amount is added to your account balance, which reduces your available credit. All purchases are tracked and reported to you, along with any accrued interest, via periodic billing statements.

    Generally, each billing period spans 30 days, with payment due no less than 21 days following the issuance of the billing statement. Most credit cards offer a grace period on each bill. Essentially, this allows you to avoid any interest charges by paying the entire balance by the due date. If you pay less than the full balance, you lose the grace period privileges. This means you will be charged interest on the unpaid portion of the balance, and you will be charged interest right away on any new purchases.

    Clearly, it’s advantageous to pay your credit card balance in full each month by the due date. Unfortunately, this isn’t always possible. Regardless, you must pay at least the stipulated minimum amount by the due date. Failure to do so is likely to result in late fees, a higher APR, and a delinquency notice on your credit report.

    Key Differences: Line of Credit vs. Credit Card

    A line of credit and a credit card are both forms of revolving credit that provide borrowers a convenient way to access money. That said, there are a number of notable differences between the two. The table below summarizes them.

    Key FeaturesLine of CreditCredit Card
    Average APRTypically, lower than a credit card, especially when secured with collateralTypically, higher than a line of credit
    Credit LimitTypically, much higher than a credit card, especially when secured with collateralTypically, much lower than a line of credit
    Grace PeriodNo grace periodTypically, 21 days
    Draw PeriodTypically, a few years; longer periods exist, with some rare arrangements offering an infinite drawInfinite draw period, assuming you make the required minimum payments
    FeesPotentially, activation fees, annual maintenance fees, draw fees, late payment fees, and returned payment feesPotentially, annual maintenance fees, balance transfer fees, cash advance fees, late payment, and returned fees
    Credit Score RequirementsTypically calls for good to exceptional creditWide availability for high to low credit scores, with increasingly high APRs
    Rewards/PerksNo rewards/perksDiverse rewards, including cash back statement credits
    Common UsesSignificant outlays, such as capital expenditures, operating expenses associated with seasonal cyclicality, and emergency repairsRecurring expenses, such as inventory purchases, rent, utility bills, and travel expenses.

    Sensible Credit Card and Line of Credit Utilization

    In light of their differences, there are certain situations when using a line of credit is optimal and other situations where credit card utilization is more sensible.

    • Line of credit: is most useful when you have the potential for unexpected, large outlays. This includes big capital expenditures, operating expenses associated with seasonal cyclicality, and emergency repairs. A line of credit gives you the flexibility to address these issues without the need to precisely time and fund them via a cash reserve or a well-defined installment loan, which can take time to underwrite.
    • Credit card: is most useful when your potential spend is low to moderate. It’s a highly convenient way to facilitate purchases without drawing down on your cash reserve. That said, you should only use a credit card for everyday spending if you intend to pay your bill off each month by the due date. That way, you’ll avoid accumulating problematic debt and paying interest of 15-30 percent.

    While ease of use is arguably the most beneficial aspect of a credit card, many cardholders value rewards programs even more. These programs, which have become a key marketing tool for card issuers, offer bonuses you can earn by making purchases with your card. Depending on the type of program, you can earn cashback statement credits, retail shopping cards, air travel miles, lodging stays, and other perks.

    Beyond the incentives noted above, a credit card provides another major advantage to end users – fraud protection. The best credit card issuers offer cardholders zero liability in the event of fraud. This is a valuable feature, especially if you have a high volume of transactions across a diverse set of vendors.

    Alternatives to Revolving Credit

    If you like the flexibility of revolving credit, but have reservations about the exposure it could introduce to your business, it’s a good idea to explore alternatives to debt financing, including those outlined below.

    • Focus on saving. Establish a rigorous, but realistic budgetary framework – with a focus on generating savings each month. Gradually build up a liquidity reserve you can tap for unexpected operational needs and capital expenditures.
    • Establish more lenient payment plans. Work with your key vendors to extend your payment terms. This can improve your near-term cash flows and give your more day-to-day flexibility; however, obtaining more lenient terms can be difficult. You are most likely to be successful if you have longstanding relationships with your vendors and an unblemished track record of making timely payments.
    • Sell unnecessary fixed assets. Oftentimes, businesses acquire assets that become obsolete over time. Assess your stock of fixed assets to determine if you are holding onto any unnecessary equipment, furniture, or automobiles. Selling these assets could be an easy way to raise cash.
    • Leverage local support. Explore your community to find business associations, mutual assistance groups, and stimulus-oriented nonprofit organizations that can provide free consulting services, monetary grants, and donations of real assets to facilitate your business endeavors.

    Conclusion

    A line of credit and a credit card both provide borrowers a flexible way to borrow money, but they are fundamentally different. A line of credit provides you access to more cash, but the availability of the line is limited, usually, to a few years. With a credit card, your access to funds is lower and costlier, but you have the ability to utilize the credit indefinitely.

    Ultimately, it’s inappropriate to assume one form of revolving credit is better than the other. Each can be beneficial, which is why many businesses maintain both.

    Ideally, a credit card should be used for high volume transactions with relatively moderate costs, such as service subscriptions, travel expenses, meals, and supplies. If managed prudently, the card will allow you to simplify your spending channels, while avoiding interest charges and earning potentially significant rewards.

    Conversely, a line of credit should be used sparingly, perhaps, for unexpected capital expenditures or operating expenses associated with seasonal cyclicality. If your cash flows are robust, you may never need to draw on the line. Nevertheless, it will provide you access to liquidity in the event you hit a challenging stretch.