Line of Credit vs. Loan
Posted by Frank Gogol
Credit and loans are two quick ways you can get access to cash. While both offer the same benefits, there’s a striking difference between the two. If you’re looking for either a credit line or loan, you need to understand the difference first to make the right choice.
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Difference Between Credit and a Loan
To understand the difference, let’s start with the definition for both these terms. A loan is an agreement between you and a lender who provides you a lump sum of money, and you agree to pay back the amount along with interest within a certain period. Therefore, a loan is also known as an “Installment Loan.” The loans are amortized more often than not. That means you repay the same amount over the years till you repay the entire amount.
On the other hand, a line of credit is a revolving account with a set limit. This allows you to borrow and spend as much or as little as you want, repay the amount, and then borrow again. You can continue this cycle as long as you’re not exceeding the limit and making payments on time, which is usually 40-50 days from the day you borrowed. A credit card is the most common example of a line of credit. There are also other examples like a Home Equity Line of Credit (HELOC) or a business line of credit.
So the main difference between credit and a loan is:
- A loan offers you a lump sum upfront, which you repay over time.
- Credit offers you a limit, and you spend as much of it as you want.
Types of Loans
If you’re considering loans for your financial needs, there are different types of loans available to you. Those are:
With a secured loan, you get money by offering one of your assets as collateral to the lender. The asset can be your home, your car, gold coins you might possess, or anything that is of monetary value. In a few cases, stocks and bonds can also be used. Thus, secured loans are protected by your asset. If you fail to repay the amount within a given period, the lender holds the right to sell your property to recoup the amount.
As opposed to secured loans, unsecured loans are not protected by any asset. This means you’re not required to submit your assets as collateral to get the loan amount. Unsecured loans are less common than secured loans and come at a higher interest rate. This increase is justified since companies are taking a higher risk in offering the amount to you. If you’re opting for unsecured loans, you should be aware of the fake agencies that offer such loans. Many such lenders are unregulated and hence cannot be trusted.
A mortgage is also a type of loan. You can either use it to buy real estate properties or raise funds to buy a real estate property. The lender will offer a lump sum amount upfront and keep the property as collateral. Then once you clear the loan amount, you can claim full ownership of the house.
Mortgage loans require credit checks and lengthy paperwork. So, it takes some time before you can get a mortgage loan to buy a house.
Lenders offer loans specifically to purchase vehicles. These are known as car loans, and you get a lump sum amount to buy a car. Similar to the mortgage loan, your car is kept as collateral. Once you clear the amount along with interest, you gain total ownership of the car. You cannot use car loans for any other purposes. It should strictly be for purchasing a car.
The last common type of loan you’ll come across is a student loan, which is offered to facilitate education. So, if you’re looking to study at a certain university but cannot afford to pay the fee, you can apply for a student loan. The lender will pay the fees on your behalf, and you pay the lender monthly. These types of loans require a good credit score. Also, your performance in academics might determine the eligibility for your loan.
Similarly, there can be specialized loans like debt consolidation loans, home improvement loans, or auto repair loans.
Types of Credit Lines
Just like there are different types of loans, there are different types of credit lines. You should learn about them thoroughly before opting for any one type.
Personal Line of Credit
This is much like an unsecured loan and hence is called an “unsecured line of credit.” There is no collateral involved in this. A company offers you a certain limit based on your credit score. You can use any amount of it but cannot exceed the limit, and you must pay back the amount within a certain period. The time frame is often shorter than those offered by loans. Many financial institutions allow this line of credit for a lifetime. You can also increase the limit if you make repayments on time.
Home Equity Line of Credit
This is a secured line of credit and is backed by your home, or more precisely, its market value. One of the deciding factors in the borrowing limit is your mortgage. Therefore, if you have an active mortgage loan, you’ll likely have a low HELOC limit. Alternatively, if the property belongs to you, you can get a higher one. These also come with a drawing period of somewhere between 10-15 years. You can use the funds over and over again within this period. As compared to the personal line of credit, HELOCs come with lower fees.
Business Line of Credit
The final type of credit is the Business Line of Credit. This is offered to business owners on an as-needed basis and can be either secured or unsecured, depending on the financial institution. Profitability, market value, and balance sheet are taken into account when determining the limit for the business line of credit.
Choosing Between Loans and Credit
So how do you choose between a loan and credit? It’s actually simple, and you need to ask two questions to yourself. Those are:
- Do I need money for a specific purpose?
- Will I be using the entire amount right away?
If you need money for a specific purpose, like buying a house or a car, there are mortgage and car loans available. These are optimized for such purposes and can offer the minimum interest rate or even zero interest rate in some cases.
If you’re going to use the entire amount, you can apply for either a loan or credit. It doesn’t really matter as long as you’re getting the total amount you’ve asked for. But if you’re not going to be using the total amount right away, it’s best to opt for a line of credit. Because with a loan, the interest rate will be charged for the total amount you’ve borrowed, irrespective of whether you’ve used the amount or not. There are no such obligations with a line of credit, and the interest rate is applicable only on the amount you use from the available limit.
Those are the basic differences between a credit line and a loan. There can be other factors, as well. Still not sure? Share your queries with us in the comments below, and we will get back to you.