What is a line of credit in accounting?

10 февраля 2020 by Forex Broker simple-accounting.org

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A line of credit is a type of bank loan that has a number of specific features. In this case, the bank (lender) sets only limits on the maximum amount and the deadline for repayment of the loan. The client (borrower) determines the need for credit resources within limits. 

Line of credit definition

A line of credit is a banking service that allows you to use the bank’s money within a certain amount for a certain period of time. This service is provided mainly to legal entities and government agencies. However, when individuals are issued a credit card (with or without a grace period of credit), they also open a credit line. Thus, a line of credit definition is easy to remember. 

How credit lines work

A line of credit differs from a standard loan in that funds can be used in installments as needed. For example, a bank provides a credit line of $100,000 for a calendar year. The borrower takes this money from the bank in installments – tranches (for example, $25,000 per quarter), as well as periodically returning them.

This is convenient for those who periodically need large cash injections to finance investment programs, replenish working capital, and eliminate budget deficits. In such cases, the credit line eliminates the need to issue a new loan every time with the accompanying collection of documents, waiting for the bank’s approval, etc.

Secured and unsecured lines of credit

Unsecured credit is very risky from the lender’s point of view. That’s why it’s more expensive. This type of loan is given out with reluctance and is provided only to the most reliable clients.

The bank issues loans under the agreement to creditworthy clients (regular income, a good credit history, etc.). Financial analysts carefully assess the client’s creditworthiness, and only after assessment, the money will be available to the client within a few days.

Unsecured LOC is not guaranteed by collateral, guarantee, or otherwise. No collateral is required. Thus, the user of banking services may have no guarantors. The financial institution will provide this loan only on the basis of a credit rating. The borrower undertakes to sign a loan agreement to repay the unsecured loan.

Most lenders want to have 100% confidence that they will get their money back. Therefore, they require some kind of guarantee. This will significantly reduce the risk of losing lent money. Otherwise, the lender will not provide financing.

The bank protects its business line of credit by pledging the borrower’s property (both movable and immovable). If the borrower is not properly honest, the property will be confiscated by the bank.

Secured lines of credit are generally cheaper than unsecured loans (lower interest rates). In addition, the lender can check the client’s creditworthiness or set a limit on the transaction amount.

Revolving LOC’s

Revolving credit is one of the most common types of credit. It is also called renewable. The financial term “revolving lines of credit” itself comes from the English word “revolving,” which means rotating, turning. 

In a nutshell, its principle of operation is as follows: the borrower uses the bank’s money within the provided credit limit, and each loan repayment immediately restores (replenishes, updates) the limit for the amount of the deposit is made. You can use borrowed funds in this “revolving” mode (spent-replenished-restored the limit, and so on in a circle) as many times as you like during a long time period set by the lender.

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