No matter if it’s for planned home repairs, consolidating high interest loans, or for one of life’s many unexpected events, taking out a loan can be a great option. However, a little research will go a long way in helping you find the best choice for you.
There are so many different types of loans; it can get confusing in a hurry when comparing rates and terms. Aside from using a credit card, a personal line of credit or a personal loan can be useful options to access much-needed cash.
Both personal loans and lines of credit provide extra cash. Each is considered to be a form of credit and personal loans and lines of credit share many similarities, at least on the surface. In reality, personal loans and lines of credit operate quite differently from one another.
Read on to find out the differences between the two, how they both work, and the best personal loans and lines of credit.
What Is A Personal Loan
When most people use the term “loan” what they’re referring to is a personal loan. Personal loans are issued for a set amount of money with a specified interest rate and repayment period. Personal loans represent a form of installment credit because repayment of the loan is divided into specific amounts, called installments that are paid over time. Once the final payment has been posted, the loan is completely paid off, and the borrower’s balance returns to zero.
What is a line of credit?
With a personal line of credit, a lender will pre-approve you to borrow up to a maximum amount. You can take out as much money as you need — up to your line of credit maximum — at any given time. You generally get access to funds by writing a check, electronic transfer or, in some cases, with your ATM card. Read this article for a detailed analysis of the characteristics of a personal line of credit.
What is the main difference between a personal loan and a line of credit?
Securing a line of credit reassures the lender that you will do whatever you can to pay back the loan. Because if you don’t pay, the lender will take the collateral you put down and to recoup their losses.
An unsecured loan, on the other hand, doesn’t need any sort of collateral. Lenders are willing to take a risk on this type of loan if you can prove you’re creditworthy.
Here are some other major differences between a personal loan and a line of credit.
With a personal loan, you get a lump sum once you’re approved for a loan. Since it’s a fixed rate loan, you pay off the entire loan amount in fixed monthly payments until it’s paid off.
Most people use this type of loan to finance a large purchase or to consolidate high interest debt.
Personal line of credit
In contrast, a personal line of credit is much like a credit card, where you’re approved for a maximum loan amount, and you borrow as much as you need, as often as you need.
It offers a variable interest rate, meaning that, while it may be lower than a fixed rate loan, your monthly payments may differ month by month.
Most people take out a line of credit in case they need to cover expenses during an emergency, for overdraft protection. Some use a HELOC, or a home equity loan for home improvement projects. This is a secured loan where you put your home up for collateral.
Pros and cons of a personal loan
Personal loans are ideal for one-time expenses such as home improvements or emergency car repairs. Personal loans can also be used to consolidate credit card bills into a single payment. Except for high-interest payday loans, personal loans often carry a lower interest rate than credit cards.
Consolidating credit card payments can result in significant savings over the long run. Personal loans also carry fixed interest rates and monthly payments which help with budgeting. As long as borrowers maintain regular payments, the balance that is owed for personal loans gradually decreases until the amount reaches zero.
The main downside of personal loans is that once borrowers receive the money, that’s all that is available. It can be difficult to obtain another loan while the first loan is still in repayment. Once the first loan is paid off, borrowers have to apply all over again for a second loan. A second disadvantage of personal loans is that interest is charged from the day that the loan is dispensed, even if borrowers don’t use the money right away. Interest continues to be charged for the entire life of the loan, which often endures long after the money is long gone, which can create quite a drain on the budget.
Here is a list of the benefits and the drawbacks to consider when shopping for a personal loan
- You know what your monthly payments are throughout your loan
- Borrow only the amount you need so that you can budget better
- Rates can lower, so you can use it to consolidate high interest loans
- Many lenders will quickly approve your loan and you can see the funds in as little as a few business days
- You’ll need a high credit rating to get get the most favorable rates
- You may need to pay a penalty if you want to pay off your loan early
- Personal loans may have higher payments, especially your loan has a short term
What is a line of credit?
Lines of credit operate more like credit cards than actual loans. Like credit cards, lines of credit represent a form of revolving credit. Home equity loans are often issued as home equity lines of credit (HELOC). With lines of credit, lenders make specific amounts of money available to borrowers. Borrowers are free to withdraw the entire line of credit at once or make several smaller withdrawals up to the limit of the line of credit.
No payments are due on lines of credit until borrowers begin to withdraw funds. Repayment amounts vary according to how much is withdrawn from the line of credit during a specific payment period. As with personal loans, payments are applied to both principal and interest, and the line of credit is replenished by the amount of the payment applied to the principal.
Pros And Cons Of Lines Of Credit
The fact that the repayment plan does not begin until borrowers make withdrawals represents a significant advantage for lines of credit. The flexibility of the withdrawal and repayment process is another advantage for lines of credit. This flexibility makes lines of credit ideal for ongoing expenses, which is one reason why so many business owners prefer lines of credit to conventional business loans.
Individuals also find lines of credit can come in handy to cover long-term projects like remodeling and physical therapy for severe injuries. Borrowers can maintain a cycle of borrowing and repayment until the entire project is complete. The revolving nature of lines of credit means that funds are more likely to be available when they’re needed.
However, the revolving nature of lines of credit can also be a disadvantage. It’s very easy to fall into an endless trap of borrowing and making only partial repayments. Lines of credit also often have interest rates and monthly payments that vary depending on market conditions and how much has been borrowed. When the life of a line of credit has expired, borrowers must pay off the entire balance, either in a single payment or installments, just as with a personal loan. But if the line of credit expires when the balance is high, the repayment amount can be quite significant.
Here is a list of the benefits and the drawbacks to consider when shopping for a line of credit.
- You only need to borrow the money you need
- Only pay interest on the money you actually borrow
- Flexible repayment options
- Constant access to funds
- Typically you qualify for lower average APR than credit cards
- Unsecured credit lines risk no collateral
- Option to provide collateral for lower interest rates (secured loan)
- Fewer restrictions on loan purpose
- Ideal for long-term projects with open-ended costs
- Good for temporary cash shortfalls
- No withdrawal limits (up to credit limit)
- You can’t deduct the interest as an expense
- The variable rate on the line of credit may increase
- Some lenders charge annual/monthly maintenance fees
- Fixed rate loans tend to have lower rates
- Not a great option for debt consolidation
- Fees/APRs vary widely by lender
- Some lenders require you to have a checking account with them
- You need good credit (although some lenders do cater to poor credit customers)
- Not a great option for long-term cash shortfalls
- Some consumers may be tempted to overspend
- A high credit usage could hurt your credit score
What’s easier to get – a personal loan or a line of credit?
There really isn’t a clear answer as to which type of loan is easiest to get approved for. Lenders will look at your creditworthiness to determine the loan amount, length of of term, or rate you’ll be approved for.
Generally speaking, the higher your credit score, the more likely you’ll be able to get a more favorable rate. It also means you’ll be able to get an unsecured loan.
For those who have fair to poor credit scores, you may still be able to get a fair rate, but you may want to consider a secured loan or secured line of credit. That way, you have a better chance of getting a lower rate and a higher loan amount. The downside is you could lose the collateral if you fall behind on payments, so think carefully before signing on the dotted line.
Since there isn’t a clear winner, the best way to determine the type of loan to get is to figure out why you want to the loan. One-time large purchases are usually better suited for personal loans. On the other hand, if you’re not sure how much money you need but you want fast access to cash, a personal line of credit may be your best bet.
Can a personal line of credit help your credit?
Both types of credit can help your credit. Of course, they will only help when lenders report your payments to credit bureaus and you’re making timely payments.
Improving your credit score can help you get a lower rate if you choose to refinance your loan. If you can ensure you make on-time payments, taking out a personal loan can be a great idea.
There is an additional issue to keep in mind with lines of credit. Since it’s a revolving line of credit, how much you actually take out can help or hurt your credit score. You see, credit utilization as a factor credit bureaus use to calculate your score. Credit utilization is the ratio between of your line of credit balance to your credit limit. That means, the more you take out, the higher the ratio, meaning, which will hurt your credit score. However, the balance of a personal loan does not affect your credit utilization ratio.
A good rule of thumb to follow with all types of revolving credit is to keep your credit utilization ratio at 30% or lower.
FAQ on Line of Credit
What is a line of credit and how does it work?
A credit line allows you to borrow in increments, repay it and borrow again as long as the line remains open. Typically, you will be required to pay interest on borrowed balance while the line is open for borrowing, which makes it different from a conventional loan, which is repaid in fixed installments.
What is the difference between a loan and a line of credit?
The main difference between a loan and a line of credit is how you get the money and how and what you repay. A loan is a lump sum of money that is repaid over a fixed term, whereas a line of credit is a revolving account that let borrowers draw, repay and redraw from available funds.
Does a line of credit build your credit?
With a secured card, you can make a small deposit—typically a couple hundred dollars—with the credit card issuer and get a card. Your card’s credit line is usually, but not always, your deposit minus any fees charged by the card issuer. Some issuers will give you a credit line larger than your deposit.
What is a good rate for a line of credit?
Lines of credit often have interest rates similar to those for personal loans (about 3% to 5% just now). Minimum monthly payments are 3% of the balance plus interest (if you have any balance).
Is a line of credit easier to get than a loan?
Personal loans are easier to budget for when compared with lines of credit. Yet lines of credit can offer you flexibility when borrowing. With a line of credit, you can borrow up to your maximum limit, repay the funds and borrow again as needed.
A Personal Loan Vs Lines Of Credit: Which Should You Choose?
Given the choice between a personal loan and a line of credit, which should borrowers elect? It depends on their circumstances and preferences. In general, personal loans are well-suited for one-time purchases, while lines of credit are a good choice for borrowers who need funds on open ended projects.
To find the best fit for you, review and compare the best personal lines of credit and personal loans.
Audrey Henderson is a Chicagoland-based writer and researcher. She holds advanced degrees in sociology and law from Northwestern University. Her writing specialties are sustainable development in the built environment, policy related to arts and popular culture, socially and ecologically responsible travel, civic tech and personal finance.