Personal loans and lines of credit are both ways you can borrow money to accomplish your goals. However, the way each type of borrowing works is very different.
Personal loans vs a line of credit
Although both a personal loan and a line of credit allow you to borrow money, functionally, they work differently. One gives you a lump sum of money up front, with fixed monthly payments. The other allows you to use the cash you need at a certain point in time and pay it back during a specified timeline.
Both are great ways to borrow money without having to offer any sort of collateral. However, both have different uses that depend on your own personal finance habits.
Personal loans give you a fixed amount of money at a set time. They require monthly payments with fixed interest rates, with a pre-set repayment period. They are best used to finance large one-off purchases, such as debt consolidation, large purchases like new furniture or home renovations, paying off student loans or medical debt. Because of the set repayment terms, personal loans are easy to budget for.
Line of credit
A personal line of credit works a bit differently. The mostly used line of credit is a credit card. Lines of credit are a type of revolving credit, with a credit limit – the maximum you can borrow at one time – with a variable interest rate. Lines of credit are best for when you are not exactly sure how much you need to borrow and for emergency situations.
Your monthly payments are not set, but dependent on how much of your credit line you use each month. Often, your credit card company will require some sort of minimum payment towards your balance each month. In addition, you will only be paying interest if you do not pay your bill off in full each month
Personal loans and lines of credit have different qualification requirements, but, generally speaking lenders look for the following:
- Strong credit history on your credit report, including on-time payments and a good credit score
- A good debt-to-income ratio
- Proof of stable income, which may include checking account information
The biggest differences between a line of credit and personal loans is interest rates, how you receive loan funds and how you repay your lender.
Starting with interest rates, a personal line of credit often will have a higher interest rate than a personal loan. In addition, while a personal loan has a fixed interest rate, a credit card, or line of credit, has variable interest, meaning that your interest can change.
Another major difference is how you receive your money. Personal loans give you the entire amount of the loan upfront. After this, you will pay off the loan slowly over a set period of time, as determined by the loan terms. Your monthly payment is also set at a fixed amount.
Lines of credit are more similar to how a credit card works. They have a draw period when you borrow money up to your credit limit and then a repayment period when you must pay back the loan. With a line of credit, you use the money as you need it and make payments on what you borrowed at the end of each month. Lines of credit often come with a minimum monthly payment. However, you should always pay back the bill in full each month to avoid accruing any interest.
In addition, personal loans and lines of credit have different loan limits – or limits on the amount you can borrow. Lines of credit often are better if you have no idea how much money you are going to spend on an on-going project. They often have higher limits than personal loans.
Similarities between lines of credit and personal loans
The biggest similarity between the two is that they both require interest payments and a hard credit check to be approved. In addition, both are a type of loan that is unsecured, meaning that they do not require the use of collateral, making them less risky than other loan types.
Both also have similar baseline qualification requirements. Generally speaking, the better your credit score and the cleaner your credit report, the better your loan terms will be – including better interest rates and repayment terms.
In a nutshell
The main deciding factor between the two should lie in the purpose of the loan and the amount you need to borrow. Always do your homework before deciding which type of loan best fits your needs and your lifestyle.