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 has a better interest rate? Which is right for me right now? What is the benefit of obtaining a personal loan? Let’s walk through some answers.
The Difference Between a Line of Credit and a Loan: The Short Answer
On the one hand, a personal loan gives a borrower a lump sum, which they pay back with interest, on an agreed-upon schedule. On the other hand, a line of credit gives a borrower access to funds up to a maximum amount. In this case, they don’t have to use it all, and payments 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 make an informed choice.
What is the Benefit of Obtaining a Personal Loan?
This may be the type of borrowing you’re most familiar with. A lender provides a lump sum to the borrower on agreed-upon terms, with a payment schedule in place to pay the amount back, plus interest and any other fees.
There are a number of types of loans commonly used today, including:
- Student loans
- Auto loans
- Personal loans
- Payday loans
The application process for a personal loan 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 rate may come with it.
Where are 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 of default on the loan. This may be a vehicle or their home. An unsecured loan does not require any collateral.
A Line of Credit: Explained
A line of credit is what’s referred to as “revolving credit.” This product allows the borrower to take out money as they see fit or as needed, as opposed to borrowing money all at once. A line of credit will have a credit limit, and the borrower may take out as much or as little money as needed, up to that limit.
The process for a person to apply for a line of credit is similar to applying for a loan. Eligibility is also assessed by the 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 3 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 will apportion charges based on what you’ve borrowed.
One of the key differences is that credit cards generally have an interest free period, whereas a line of credit may not. Credit cards also generally require the use of a physical card, whereas a line of credit is generally drawn down into the borrowers’ checking account.
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?
Generally speaking, a loan is usually used when the borrower knows how much money they will need.
These are “big ticket” items that typically require a considerable amount of money, and the borrower knows how much that amount is going to be.
You can also take out a personal loan to cover unexpected expenses or for smaller necessary purchases. If you need small amounts of money in a hurry, it may be faster to look at online options, even if they are more expensive. Going through the bank can be a lengthy process.
When Would I Use a Line of Credit?
People would 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 are often 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 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 can be hard to predict when the highs or lulls may be, so a line of credit may act as a helpful safety net.
This is another situation 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 line of credit as a safety net, you may be able to minimize some of the disruption. We know there is a lot of personal stress that comes from these situations, but you can 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, the line of credit is revolving credit, versus a lump sum paid all at once.
Personal Loan Vs. Line of Credit: Which is Better to Rebuild My Credit?
This 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.
However, we will give you as much information as we can to help you consider your options.
A Line of Credit to Help Rebuild Credit
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, while the other bills are still paid on time. If you’re up to date with all payments to your line of credit, this may 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 standing.
If you wanted to improve your credit score, you would have to focus on 3 things:
Making Your Payments on Time
This strategy only works if the line of credit payments are made on time. If they’re not, your credit score will be taking a hit with each late payment. 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 fall by 60-80 points with a late payment.
However, a regular track record of making these payments on time, while continuing to maintain other healthy credit practices, may send your credit score in the right direction. 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 a credit score any good.
Low balances are a good thing. It’s best to pay off any purchases or withdrawals made as quickly as possible. Your credit utilization ratio is the amount of credit you use, compared to how much you have available.
This makes up about a third of your overall credit score, because lenders and credit agencies want to see you’re not using up all 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.
Maintaining Regular Activity
Equally, keeping a completely untouched and unused line of credit with a zero balance is not going to help your credit score either. Ideally, you need to demonstrate that you can make smaller purchases and pay them off before the balance falls due. For example, you may consider putting your gas fill-ups on the line of credit.
Filling up the car works well, because it’s:
- Already accounted for in your monthly budget
- Something you need regularly
- A relatively small purchase that can be paid off right away
In any situation, responsible use of credit means keeping a low balance and regularly paying off purchases. This is how you can build (or rebuild) your credit.
Line of Credit vs. Loan: Key Points
We hope this article has given you some valuable information today that may help you decide between a personal loan or 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 gives a borrower a lump sum, which they pay back with interest, 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 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.
- A loan is generally used when the borrower knows how much money they will need. Whereas, people would generally look for 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 as it acts as that 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.
Want More Information on a Line of Credit?
A CreditFresh Line of Credit by CBW Bank may act as a safety net and set you on the path towards a better financial future. The process is simple, quick, and completely transparent, with clear terms and no unexpected hidden fees.
If your application is approved, you may receive a personal line of credit from $500 - $2,500. Click here to get started.