What’s the Difference Between Personal Loans and Personal Lines of Credit?

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While it’s always a good idea to create a budget and ensure you have enough savings to take care of most of your financial needs, that isn’t always possible. Sometimes borrowing money for your personal needs is the best option, and it may even make the most financial sense. That’s when you’ll have to decide between personal line of credit vs. personal loan options.

The answer for you may depend on several factors. Strategic borrowers must carefully choose the most cost-effective option that meets their unique needs. Here’s what you need to know about personal loans, lines of credit and which one may be better for you.

Personal line of credit vs. personal loan: What’s similar

Both personal loans and lines of credit provide borrowers with a way to get cash when they need it. Here are the similarities you can expect to see with a personal loan and a line of credit.

Unsecured and secured options

For both a personal loan and a line of credit, you have the option of secured or unsecured borrowing.

With a secured loan or line of credit, the borrower puts up an asset to act as collateral, in case of a default on the loan. Common examples include a vehicle for a car loan and a home for a home equity line of credit.

There are also unsecured personal loans and lines of credit, through which lenders provide funds without any collateral required. The funds are available to be used entirely per the borrower’s discretion. A credit card, for one, is essentially an unsecured line of credit; there is nothing the lender can seize if you fail to make payments (although you can get a secured card, which requires an upfront deposit). This makes unsecured personal loans and lines of credit flexible credit options to get cash for a variety of purchases or situations.

Similar application process and credit requirements

The applications for personal loans and lines of credit are similar as well. For both forms of credit, a lender will typically review an applicant’s credit history and verify their income. They use this information to approve or deny your application.

Credit requirements for personal loans and lines of credit are often similar, too. Specific credit requirements and borrower eligibility guidelines vary from lender to lender, as each sets its own criteria.

Generally, however, both a personal loan and a line of credit will require good credit for approval and excellent credit for more favorable terms. If you’re looking for a higher loan balance or low interest rates, for instance, you’ll probably need a credit score on the higher end to qualify.

The differences between a personal loan and a line of credit

While personal loans and lines of credit offer similar borrowing options in some ways, they are set up differently. From how they accrue interest to how a borrower repays them, these credit options diverge on several important features.

How funds are paid out

The biggest difference between a personal loan and line of credit is how the borrowed funds are paid out.

With a personal loan, the amount borrowed is set and paid out once in a large sum. The loan holder gets all the money upfront. Often, lenders have a minimum loan amount you must borrow, so smaller loans can be harder to get.

A line of credit, however, is revolving credit. Instead of borrowing money all at once, a line of credit allows the account holder to take out money as it’s needed. The line of credit will have a credit limit, and the borrower can take out as much or as little money as needed, up to that limit.

Interest rates

Both personal loans and lines of credit charge interest on borrowed funds, but lines of credit usually have higher interest rates than those offered on personal loans. This can make them a more costly credit option.

Interest rates on lines of credit are determined almost exclusively by the creditworthiness and income of the borrower. The rates on lines of credit are also often variable, so a lender can raise them after the money has been borrowed.

A personal loan might also have a variable rate, but it is more common to have a fixed rate that does not change throughout the life of the loan. Personal loan interest rates are typically lower than those offered on lines of credit.

Many factors can affect personal loan rates, including the length of the loan and even the amount borrowed. This gives the borrower more options to lower their interest rate than they might have with a line of credit.

Repayment

Another factor to consider when deciding on a personal loan versus a line of credit is how repayment is set up.

A personal loan has a clear, straightforward repayment system. The borrower makes regular payments (usually monthly) for a set repayment term.

With a personal loan, monthly payments are set at the beginning of the loan. The balance and interest earned on the loan are calculated, and then it’s divided over monthly payments set to completely pay off the personal loan over the chosen repayment period.

Payments for a line of credit, however, are not set up for paying off the credit within a certain time frame. Lenders might have different formulas to determine monthly payments, but the system is often similar to how credit card minimum payments are decided.

Wells Fargo, for instance, sets minimum payments on a line of credit at the amount of your total balance when it’s $25 or less, and 1% of your balance when it’s higher than $25. Repayment periods are also not defined and might be longer than they would be with a personal loan.

Personal loan or line of credit: Which is better for you?

When deciding between a personal line of credit and a personal loan, borrowers need to look at the different features and determine which would be a better fit for their situation. With a personal loan or line of credit, which is better will come down to what kind of credit you need.

When to choose a personal line of credit

A line of credit from a bank or credit union is often used by workers who have a varied income, such as a salesperson who works on commission, or an independent contractor.

When their pay can vary so much month-to-month, they might have an ongoing need to borrow money and bridge any gaps in income. A line of credit offers funds to borrow that are available when needed.

A line of credit can also be a smart borrowing option when the total amount you will need is unknown, or when your costs will be ongoing.

A couple planning a wedding, for instance, might not know exactly what their total costs will be. Having a line of credit means that funds are available so they can borrow what they need when it’s needed, no more and no less. Then they will only be charged interest on the amount they use, which would not be the case if they took out one lump-sum personal loan.

When to choose a personal loan

For one-time transactions, a personal loan can offer a better deal and a clearer repayment plan. With a personal loan, the borrower must know exactly how much they’ll need at the start. This way they can borrow enough to cover their costs but not more than they need.

Personal loans are often used to cover expenses such as car repairs or emergency costs. Another common use of personal loans is to consolidate or refinance other debts, such as higher-interest credit card debt.

You can use this calculator to estimate your monthly payment, interest charges and the total cost of getting a personal loan.

Final word

For informed borrowers who fully understand the terms and risks of their loan or credit, either of these options can be a way to get cash when it’s needed. With both, however, responsible repayment is a must to ensure these products benefit the borrower. Particularly if you secure a line of credit, be sure to only use what you need — don’t “overborrow” just because the money is there for you to use. After all, there is no good reason to pay interest on funds you don’t truly need.

Published in Credit & Debt, Loans

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