Personal loans and lines of credit are two ways to borrow money from a bank or lender. However, there are circumstances where one may be more suitable for your financial situation than the other. Therefore, it’s important to understand their similarities and differences to avoid making financial mistakes and save more money in the long run. Here is an expert guide to help you decide which is better—a loan or a line of credit?
How Personal Loans and Lines of Credit Work
Loans and lines of credit are similar but are not the same. Here’s how they work.
How Do Loans Work?
With a loan, you will receive a lump sum you must repay in installments over a certain period. Personal loans are generally amortized. This means the payments are divided into equal portions that you must pay according to the agreed-upon schedule; this can either be within a few months or years.
How Lines of Credit Work
Meanwhile, a personal line of credit works much like a credit card. Once the lender approves the application, they’ll give you an account to withdraw cash whenever needed. The maximum withdrawable amount depends on the limit set by the lender. For example, suppose you have a credit line with a $20,000 limit. That means you can withdraw up to $20,000.
Withdrawing money reduces your available balance. You’ll have to repay the lender to increase it again. Using the $20,000 limit example, let’s say you took $1,000. You’d only be able to use $19,000 until you repay the $1,000.
What Is the Difference Between a Loan and a Line of Credit?
Besides the different ways these borrowing methods work, let’s look at various ways personal loans and lines of credit are distinct from each other.
Required Credit Scores
Most lenders will do a credit check when reviewing a loan or credit line application. However, the minimum credit score needed is usually lower for personal loans. A score ranging from 550 to 600 could still get your loan request approved.
Those applying for a personal line of credit typically need a higher credit score of at least 650 or higher. Since the amount you can withdraw over time with a line of credit is limited, the lender will want to ensure you can cover it.
Personal loans usually must be repaid according to the schedule set by the lender, which can last from just a few months or up to several years. You owe the lender nothing else after you finish paying off the loan.
Lines of credit have two different terms instead. The first is the draw period, during which you can withdraw funds from the account and make the minimum monthly payments. The draw period often lasts around 5-10 years, after which the repayment period starts. This is when you have to pay back the remaining balance with interest.
Interest Rate Types Differ
Lenders typically charge fixed interest rates for personal loans. In a fixed-rate payment plan, the entire amount gets charged with interest regardless of whether or not you use all the money. As of March 2023, personal loan interest rates in the US generally range between 4% and 36%.
Lines of credit tend to have variable interest rates instead; this means the interest rate can change depending on market rates. However, you only get charged with interest when you access the funds.
Lenders may also charge different fees for personal loans and lines of credit. For loans, they can charge origination fees for processing your application. They may also charge you prepayment penalties if you pay the loan off early—as this prevents them from collecting interest in the long run. However, they will charge late fees if you miss your payment.
Not all lenders charge origination or prepayment fees, so look for one that doesn’t include this fee to reduce your expenses.
Lines of credit can have extra fees, as well. Besides late fees, some lenders may also charge annually to maintain the account.
Similarities Between Personal Loans and Lines of Credit
Payments Have Interest
Loan and credit line payments both have interest charges—the price you pay for borrowing money. Lenders determine your loan or credit line’s interest rate based on several factors, including your credit score, income, and payment history. Generally speaking, the greater the risk of failing to pay, the higher the interest rate charged to you.
They Are Usually Unsecured
When a loan or a line of credit is unsecured, it isn’t backed by collateral. In a secured loan, the collateral is an asset, such as a car or house, that the lender will seize from you if you cannot repay the debt.
Lenders are also likely to charge higher interest rates for unsecured loans and credit lines to make up for the lesser risk on your part.
What’s Easier to Get: a Loan or a Line of Credit?
Since banks and lenders typically require higher credit scores for lines of credit, applying for one will be difficult if you have a low score. It also helps if you have been a long-time customer of that bank or lender; they are more likely to trust that you’ll be more responsible with your line of credit. You’ve already shown them that you can manage your finances well.
It’s easier to get personal loans since lenders have less stringent requirements for them. They can still approve your application even if you have a bad credit score, so long as you can sufficiently prove that you have a steady source of income to afford the payments.
Can You Open Both a Personal Loan and a Line of Credit?
While you could take out loans and open credit lines simultaneously, it’s not advisable if you’re trying to simplify your financial situation. You’d end up juggling several monthly payments—this can make it more difficult to make ends meet when you have other expenses.
A problem with relying on a line of credit is that it can put you in a constant state of debt if you overuse it while only making minimum payments. In addition, knowing that you still have some balance left in your account can make it tempting to withdraw more than you need. Budgeting for your credit line payments can also be difficult because of their floating interest rates.
With this in mind, it’s no surprise that credit card debt is a major factor in the drastic debt increase among American households in the past fiscal quarter of 2022.
However, a personal loan can be easier to manage due to its lump sum amount and fixed interest rates for the payments. You don’t have to worry about paying back the lender more than what you’ve budgeted for the month.
Choosing Which is Better: Loan or Line of Credit
With all of these in mind, here are some pointers to help you pick a borrowing option:
Consider applying for a Line of Credit If:
- You’re unsure of how much cash you need to borrow. This can be particularly helpful when you have ongoing expenses. For example, you might be paying for a loved one undergoing medical treatments with no definite end to them.
- You want easy access to funds whenever needed. Unlike loans, you don’t have to apply again to get more money.
- Your finances are stable enough to afford a credit line’s fluctuating interest rates and the future repayment period.
Apply for Loans If:
- You have a low credit score, or you’ve just started building your credit. You need not worry much about these since lenders are less strict.
- You have a big, one-time expense, such as buying a car, appliance, or plane ticket. A loan is better if you know the exact amount you need.
- You need more control over the debts you have to pay. A loan’s fixed rates and lack of repayment period would be more suitable in this regard.
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