Line of Credit vs. Personal Loan Explained
Posted by Frank Gogol in Loans | Updated on May 30, 2023
A personal loan can be a good way to get money for important short-term needs. Another option you can explore is a line of credit (LOC). Numerous lenders in the U.S. offer both personal loans and lines of credit. When choosing between a line of credit and a personal loan, there are many important factors to consider. Read on if you need help deciding which of these two products works better for your lending needs at the moment.
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Line of Credit vs. Personal Loan
Lines of credit and personal loans are both types of financial products, but they work slightly differently in how interest is charged, how long they last, and how repayments work. The definition of each type of lending product is outlined below.
What is a Line of Credit?
A line of credit is a special type of lending product offered by some lenders. Rather than a lump sum, a line of credit makes any sum of money available to you up to a set borrowing limit. You can borrow as much or as little as you need to at any time. You only pay interest on the outstanding balance.
Many people use lines of credit to pay for expenses that they cannot predict, for example:
- home remodeling or repair projects
- large, unexpected expenses
- to cover unexpected loss of income.
What is a Personal Loan?
A personal loan is a sum of money that you borrow from a lender and receive as a lump sum. Interest is charged on the entire lump sum, and the loan must be repaid on a schedule. This schedule is called the repayment period.
Personal loans are usually unsecured, although secured personal loans also exist. You can spend the funds from a personal loan as you see fit.
People often get personal loans to cover major, well-defined expenses such as:
- large medical bills
- fixed price home or auto repair bills
- small business start-up capital
- debt consolidation.
Key Differences Between Personal Loans and Lines of Credit
When comparing a line of credit to a personal loan, there are some important differences between the two to keep in mind. A few of these are listed below.
- Collateral: Personal loans are usually unsecured, whereas lines of credit are sometimes secured with valuable assets. Generally, if you provide collateral for your line of credit, you will get a better deal, such as a reduced interest rate.
- Interest: Interest on a line of credit is only charged on the amount of money you have used from the facility. If you do not use the facility, you may still pay some fees, but you will not pay interest. On the other hand, as soon as you receive the lump sum of a personal loan, interest is charged on the amount you have not paid back. Whether you spend the money or not, interest will be charged on your loan. You will be required to stick to a repayment schedule.
- Lifetime: Once you have fully repaid a personal loan, that is the end of the agreement between you and the lender. However, you can repeatedly use and repay a line of credit for as long as it remains open. This period can vary from a few months to years.
Key Similarities Between Personal Loans and Lines of Credit
There are also some important similarities when comparing a line of credit and a personal loan. These similarities include:
- Credit check: Some lenders offer prequalification, which does not affect your credit score. However, when you submit an official application for a personal loan or line of credit, the lender will submit a hard credit check to various credit bureaus. This causes a decrease in your credit score.
- Interest: Although the exact way interest is charged varies between the two, both types of products charge interest on the outstanding balance.
- Qualification: The approval requirements (e.g. minimum credit score, income, etc) are usually quite similar when comparing a line of credit vs personal loan.
- Collateral: Although secured lines of credit (e.g. home-equity line of credit) exist, many lenders offer unsecured lines of credit along with unsecured personal loans.
Which is the Best Option for You?
If you need money to cover important expenses, the choice between a line of credit vs personal loan depends on your needs. The best option for you depends on various factors including:
- Amount: If you know the exact amount you will need, then a personal loan is a simple way to get that amount.
- Flexibility: If you are unsure how much exactly you need, or you need a ‘rainy day’ safety net, then a line of credit is one potential way to have debt funding available whenever you need it.
- Predictability: Lines of credit generally charge variable interest rates, and the interest charged depends on how much of the facility you have used. That means that your monthly repayment can vary widely from month to month. If your finances are in a precarious state, then the predictable, unchanging payments of a fixed-rate personal loan may be a better choice for you.
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When deciding between a line of credit vs personal loan, it is important to keep in mind the characteristics of each. Although there are many similarities between the two, such as the credit checks that will be required, and the requirements that the lender will set out for approval, there are also some differences. Most importantly, the way repayment works and how interest is charged on these products differs. These differences mean a personal loan is best when you know exactly how much money you need, but a line of credit is better when you need flexibility. Finally, if your finances are in a precarious state, then the predictable payments of a fixed-rate personal loan might be better than those on a variable-rate line of credit which can change a lot from month to month.