A Line of Credit vs. a Loan: Which is Right For Me?
Published on March 26th, 2019 by CreditFresh
It’s true, emergencies don’t care about your savings or your credit score. We’re all vulnerable to medical bills, changes in employment, or car repairs. When these events happen, you may find yourself considering whether a line of credit or a personal loan is the best option for you.
So, what’s the difference between a line of credit and a personal loan? Which is right for me right now? What is the benefit of obtaining a personal loan? Let’s walk through some of these answers.
The Difference Between a Line of Credit and a Loan: The Short Answer
While a personal line of credit is still considered a loan, there are some distinct differences between a personal line of credit and other types of personal loans. A personal loan gives a borrower a lump sum, which they pay back with interest, on an agreed-upon schedule. A personal line of credit, on the other hand, gives a borrower access to funds up to a maximum amount. In this case, they don’t have to use it all, and interest and/or other charges are based on how much is used.
Each method of borrowing has its own benefits, and each has specific circumstances where it may be the right call. Let’s take a deeper dive into the line of credit vs. loan comparison to help you have a more informed understanding between a line of credit and other types of loans.
What is the Benefit of Obtaining a Personal Loan?
This may be the type of borrowing you’re most familiar with and that differs from a type of loan like a line of credit. A lender provides a borrower with a lump sum on agreed-upon terms, with a payment schedule in place to pay the amount back, plus interest and any other fees.
There are several types of personal loans commonly used today, including:
- Student loans
- Auto loans
- Personal loans
The application process for these types of personal loans is similar in most cases. A borrower’s eligibility is assessed by the lender, based on a number of factors that may include employment status, income, credit history or assets owned. The lender factors in all of these things to determine how much the would-be borrower may be eligible to borrow, and what type of interest rates or fees may apply.
Where are these loans available? Some options include:
- Online lenders
- Private lenders
Secured Loan vs. Unsecured Loan
In some cases, the borrower may put up an asset that they own to act as collateral in case they default on the loan. This may be a vehicle or their home, but it may also be a variety of belongings that have value.
An unsecured loan does not require any collateral.
A Line of Credit: Explained
A personal line of credit is what’s sometimes referred to as “revolving credit.” This type of financial product allows a borrower to take out money, up to their available credit, as they see fit or as needed, as opposed to borrowing a lump sum of money all at once. A personal line of credit will have a credit limit, and the borrower may take out as much money as needed up to that limit that they have available.
With some lines of credit, money will be drawn into your bank account, while with others, you’ll charge a purchase to your line of credit, similarly to how a credit card works.
The process for a person to apply for a line of credit is similar to applying for other types of loans. Eligibility is also assessed by a lender, based on many of the same factors as a loan.
Again, both secure and unsecured options are available, so collateral may or may not be required. There are essentially three major types of lines of credit:
- Home equity
Where are lines of credit generally available?
- Online lenders
- Private lenders
What’s the Difference Between a Credit Card and a Line of Credit?
This is another very popular question. Both of these options may give you access to funds up to a certain amount, and both may adjust charges based on what you’ve borrowed.
One of the key differences is that credit cards may have an interest free period, whereas a line of credit may not. Credit cards also generally require the use of a physical card in some situations, whereas a line of credit generally doesn’t.
A Line of Credit vs. a Loan: When Would I Use Either?
One of the key differences is when and where you might use them. Let’s take a look at some possible use cases for each.
When Would I Use a Loan That Isn’t a Line of Credit?
Generally speaking, a personal loan is usually used when the borrower knows how much money they will need.
Circumstances include the purchase of a “big ticket” items that typically require a considerable amount of money, and the borrower knows how much that amount is going to be.
You may also take out a personal loan to cover unexpected emergency expenses.
When Would I Use a Line of Credit?
People generally look for a line of credit if they’re not sure of the exact amount they need, or when they may need it.
This is why lines of credit may often be used for:
Irregular or Unpredictable Income
A line of credit may be used as a way of helping someone with an unpredictable income, such as a salesperson that works mainly on commission. Or it may be used by someone who is self-employed and doesn’t have a stable salary.
In either case, sometimes the cash flow is good, and sometimes it’s not. It may be hard to predict when the highs or lows may be, so a line of credit may act as a helpful safety net in case an emergency situation comes up.
These are other situations where a line of credit may act as a safety net.
Unplanned expenses happen all the time. It’s hard to predict:
- Car accidents
- Appliances breaking
- Medical or dental costs
- Veterinary bills
- Home repairs
You may not have the funds you need to deal with these situations, but that doesn’t stop them from happening.
They say, “life happens” when one of these situations pops up. But, with access to a loan like a line of credit as a safety net, you may be able to minimize some of the impact “life” has on your finances. There’s a lot of personal stress that comes from emergency situations situations, but you may eliminate some of that stress by not having to ask, “How am I going to pay for all of this?”
In short, in the personal loan vs. line of credit comparison, there’s no one-size fits all answer. What you do now know is that the line of credit is revolving credit, while other types of loans – like a payday or installment loan – are a lump sum paid all at once or in installments.
Personal Loan Vs. Line of Credit: Can They Help Rebuild My Credit?
Here is another question with no simple answer or blanket solution for every case. Each person’s financial situation is unique. Also, any type of borrowing needs to be done thoughtfully and responsibly to help your credit.
A Line of Credit to Help Build Credit History
As we mentioned earlier, life is full of unexpected surprises. Someone with limited or unpredictable income may use the line of credit as a safety net when these things happen.
If you’re unprepared for a big expense, uncomfortable decisions are sometimes made. Maybe the phone bill doesn’t get paid this month, or maybe the rent will have to be late. Late payments may damage your credit, but you may not feel like there’s any other way.
The line of credit may be the “other way” you’re looking for. This safety net may cover the unexpected costs. If you’re up to date with all payments to your line of credit, this may help prevent damage to your credit score.
Of course, credit scores are very complex and are affected by a number of factors, but the above example is one where a line of credit may help build your credit history.
If you want to build your credit history, you would have to focus on 3 things:
Making Your Payments on Time
Paying bills late may impact your credit history negatively. In fact, MSN Money’s Liz Pulliam Weston has said that a single late payment on a line of credit may lower a 780 score by 80-100 points. A score of 680 may potentially fall by 60-80 points with a late payment.
However, a regular track record of making payments on time, while continuing to maintain other healthy credit practices, may build positive credit history. So, make sure you’re including these payments in your monthly budget and setting reminders in your calendar for the due date.
Keeping a Low Balance
Constantly keeping a balance near or at the limit of a line of credit is also not going to do you any favors. It affects your credit utilization rate, which is the amount of credit you use, compared to how much you have available.
Credit utilization makes up about a third of your overall credit score, because lenders and credit agencies want to see you’re not maxing out your credit as soon as you get it. So, what’s a good ratio? Experts recommend doing everything you can to keep your ratio below 30% of your available credit.
Line of Credit vs. Loan: Key Points
Hopefully, this article has given you some valuable information today that may help you understand the different between a personal loan and a loan like a line of credit. Remember, your financial situation is unique and needs to be treated that way. But to recap some of the points we covered today, broadly speaking:
- A personal loan typically gives a borrower a lump sum, which they pay back with interest and/or charges, on an agreed-upon schedule. A line of credit gives a borrower access to funds up to a maximum amount.
- A line of credit is what’s sometimes referred to as “revolving credit.” It allows the borrower to take out money as they see fit, as opposed to borrowing money all at once.
- Depending on the situation, a personal loan is generally used when a borrower knows how much money they will need. Whereas, people would generally look for a loan like a line of credit if they’re not sure of the exact amount they need, or when they may need it.
- A line of credit is also a helpful safety net in case one of life’s unexpected and expensive emergencies come up. It can also be used as a safety for people with unpredictable income.
- A line of credit may be helpful in building credit history as it acts as a safety net, while your payments on that line of credit are reported to credit agencies.
Remember, just because one of these methods worked for a friend or family member doesn’t mean it will necessarily work for you. Always look at the whole picture to make the best financial choice for your situation.