Personal Loans vs. Line of Credit – What's the Difference?
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Whenever you need funds, you will think of borrowing. But there are several debt products available in the market like personal loans and lines of credit. When comparing two products, wouldn’t you wish someone just told you what the best option was? However, life doesn’t happen like that and before you make a decision, you need to understand how the product works, its pros and cons, and then choose one.
You will find all types of loans that are designed for specific needs but when you need money for a reason that does not fit into any of the categories, a personal loan or a line of credit might be a good idea. Both can help reach the same goal in different ways.
If you are thinking of applying for a personal loan or opting for a line of credit, we will help you choose. Here is everything you need to know about each.
In this article
What is a personal loan?
A personal loan is a method of financing that can be used for various expenses like paying for your wedding, debt consolidation, or remodeling your house. Most loans have limits between $1,000 and $100,000 but the amount will depend on the lender and your creditworthiness. You will receive the amount in a lump sum, and can repay it through installments, ranging from two to seven years.
It is a non-revolving product which means you can use the amount only once and not again and again. Your loan could be secured or unsecured. A secured loan will need collateral while an unsecured loan does not need one. If you default on a secured loan, your lender will repossess the asset you have provided as the collateral to recover the amount. If there still is an outstanding amount, your lender will pursue you for it. This is also why secured loans come at lower interest rates as they carry low risk.
In contrast, the approval of an unsecured loan will depend on your credit history, and there is no certain way the lender will get the money back even if you default. Hence, the loan is usually for a lower amount and has higher interest rates than secured loans. If you are planning a wedding and the venue requires half of the amount up front, you can take out a personal loan to cover the deposit and make the monthly payments to repay it.
Before applying for a personal loan, you must consider your credit score, loan rates, fees, and repayment terms. The higher the credit score, the more likely you will get approved for a lower interest rate. You can look for secured loan options if you do not qualify for an unsecured personal loan.
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When is a personal loan a good option?
Personal loans can cover emergencies like auto repairs, home improvement projects, debt consolidation, or unexpected bills. It is ideal to opt for a personal loan when you are certain of the amount you will require. If you do not know the exact amount you might need, it is better to choose a line of credit. That said, it is only suitable for those who can make consistent monthly payments.
Pros and cons of a personal loan
Pros
- Monthly payments and interest rates remain fixed.
- Few qualification requirements
- Can be used for a variety of purposes
- Funds provided in lump sum amount
Cons
- Pay interest on the full loan amount
- Origination fees and prepayment fees
Types of personal loans
There are different types of personal loans available today. Let us take a look at them.
- Fixed-rate loan. A fixed-interest rate personal loan is one that carries a fixed and consistent interest rate on the entire term of the loan.
- Variable-rate loan. The variable interest rate loan has a flexible interest rate and your monthly payments will change according to the change in the rate of interest. You will not pay the same amount each month for the loan term.
- Debt consolidation loan. When you consolidate all the debts into one, it is known as a debt consolidation loan. Through it, you only have to make one regular payment and not worry about multiple payments. Most of the debt consolidation loans are unsecured.
- Student loans. A common form of debt today, a student loan, is also known as an educational loan. It relies on your income and credit score but it helps serve the purpose of meeting your education expenses. The payment will remain deferred as you attend school and for the first six months once you graduate.
- Automobile loan. An automobile loan is a secured loan and the collateral is the vehicle in question. The lender will advance the amount of the purchase price to the seller after reducing the down payments made by the borrower. In case the borrower defaults on the repayments, the lender will repossess the vehicle and pursue the debtor for the remaining balance.
- Home renovation loan. A home improvement or renovation loan helps the borrower meet the repair needs. The repairs and renovation will likely increase the value of the home.
Related: Five Warnings Signs Your Personal Loan Is a Bad Deal
What is a line of credit?
When you apply for a personal line of credit, it works just like a credit card. The lender will approve a specific amount which can be as high as $100,000 or sometimes $500,000. However, you will not receive this amount in the form of a lump sum. But you can draw up to this amount as and when you need.
You are liable to pay interest on the amount borrowed and then you will repay the balance in fixed monthly installments. Let us take an example of a line of credit. If you are getting married, you will have to consider the expenses of booking a venue, the caterer, and a florist, and everyone will ask for a deposit. You might not have enough savings to pay for all these expenses, but you are also unsure about the exact amount you need. This is when you can use a personal line of credit.
When you apply for an unsecured line of credit, the lender will decide the maximum amount you can borrow and you can choose to borrow as much as you need or the maximum. To avoid paying interest, you need to pay the balance off in full by the monthly due date and make minimum monthly payments consistently. The interest will only accrue after you take out cash against the credit line. A credit card is an example of a line of credit.
Most lines of credit are unsecured but there are some like home equity lines of credit which are secured and use the home as collateral. There is a draw period and a repayment period. You can borrow as needed in the draw period, and once the repayment period starts, you cannot borrow any more until the balance is paid. It usually impacts your credit score and credit report faster.
When is a line of credit a good choice?
If you need a little more flexibility in terms of the amount, a line of credit is a good choice. You can use it for long-term projects, debt consolidation, education expenses, and emergency expenses. You can use as much or as little of the money as you need. It works well when you are unsure of the amount of money you need, but you can pay the interest regularly. It is a long-term borrowing option that you can keep open for as long as you want to.
Related: Zable Review – Personal Loans and Credit Card Solution.
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Pros and cons of the line of credit
Pros
- Consistent access to funds
- Pay interest only on withdrawals
- Funds can be used for anything
Cons
- Higher interest rate than a personal loan
- Variable interest rates mean the monthly payments vary
- This can lead to overspending
- Maintenance fees
- Requires good to excellent credit
Types of credit lines
A personal line of credit is explained above, but you should be aware of two more types of credit lines.
- Home equity line of credit. A home equity line of credit is a secured loan supported by your home’s value. It has a credit limit of 80% of your home’s market value minus the amount outstanding on the mortgage. It usually comes with a drawing period of 10 years and has a lower interest rate than a personal line of credit since it is a secured loan.
- A business line of credit. A business line of credit will be used by the business as and when needed. When extending funds, the lender will consider the company's risk, profitability, and market value. The loan could be secured or even unsecured, and the interest rates are usually variable.
Key differences
Rate of interest
The interest rate on a personal loan is usually fixed and ranges between 3% to 36%. However, your rates will be based on your creditworthiness, and you can enjoy a favorable rate if you have good credit. In contrast, a line of credit comes with a variable interest rate and will depend on the prime rate. So, if the prime rate increases, the interest rate on a line of credit will also increase.
Loan amount
You will enjoy a higher limit on a line of credit than a personal loan. In most cases, a personal loan will range between $50,000 to $100,000, while a line of credit can go as high as $500,000.
Credit limit
A personal loan comes with a non-revolving credit which means that the borrower can use the funds only one time and they will make the principal and interest payment until the entire debt is paid off. But a line of credit works differently. Here, you will receive a set credit limit, and make regular payments for principal and interest. You will have consistent access to the funds and can use them as and when you need them.
Minimum credit score
The minimum credit score requirement for a line of credit will be higher than that of a personal loan. You can find personal loans for bad credit, but you must have a minimum credit score of 670 to apply for a line of credit.
Fees
There will be fees applicable for both financing methods. You will pay an origination fee when you take a personal loan, which usually ranges between 1% and 8%. But there are ways you can avoid the origination fee on loan. On the other hand, a line of credit will have an annual fee in the draw period and it could be $100 or sometimes higher.
Loan term
Personal loans have terms ranging from two to several years, while a line of credit has a tenure ranging from five to ten years.
Repayment
The repayment on your personal loan will start immediately until you repay the entire loan amount in full. But in a line of credit, you will make minimum payments in the draw period and pay the balance in the repayment period.
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FAQs
Is there any disadvantage to a line of credit?
You can use a line of credit again and again like a credit card, but it does have a higher interest rate. It can also lead to overspending if you are not careful about where you use the funds.
Can I use a personal loan just like a credit card?
The personal loan is not a revolving product which means you cannot use it as a credit card. The lump sum is available for single use only.
Will there be a credit check when I apply for a line of credit?
Yes, there is a credit check when you apply for a line of credit, and it will lead to a hard inquiry on the report.
The bottom line
Now that you know the differences between the two types of debt products, choose wisely when you decide to borrow. There is no single debt product that can fit your needs. You will have to consider your requirements, financial situation, eligibility, credit score, and loan terms before you make a decision.
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Editor
Vandita Jadeja is a financial writer and editor at Joywallet. She loves to read and write about money and brings a decade of experience from the financial industry.
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