It’s true, emergencies don’t care about your savings or your credit score. We’re all vulnerable to unforeseen expenses such as medical bills 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 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 and/or fees, on an agreed-upon schedule. A personal line of credit, on the other hand, gives a borrower access to funds up to a maximum credit limit. 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 applicant 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 or servicers
- 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. This would be referred to as a secured loan. Keep in mind, however, that an unsecured loan does not require any collateral.
A Line of Credit: Explained
A personal line of credit can be categorized 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, assuming their account is in good standing.
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 someone 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 or servicers
- 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 that isn’t a line of credit is usually used when the borrower knows how much money they will need.
Circumstances include the purchase of “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 apply for 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.
This is why lines of credit may often be used for:
1. 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.
2. Emergency Situations
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, 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 know now is that lines of credit are a type of revolving credit, while other types of loans – such as installment loans – are a lump sum generally paid back in installments.
Personal Loan Vs. Line of Credit: Can They Help Build My Credit History?
Here is another question with no simple answer or blanket solution for every case. Keep in mind that each person’s financial situation is unique and that credit scores are very complex and are affected by a number of different factors.
Depending on some of those factors, if you’re up to date with all payments to your loan or line of credit, this may help prevent damage to your credit score. No matter what, any type of borrowing needs to be done thoughtfully and responsibly.
Line of Credit vs. Loan: Key Points
Hopefully, this article has given you some valuable information today that may help you understand the difference 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 other 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 categorized as “revolving credit.” It allows the borrower to draw funds 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.
- A line of credit is also a helpful safety net in case one of life’s unexpected and expensive emergencies come up.
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.