What is the difference between a Personal Loan and a Line of Credit?
So you need a Personal Loan. Or do you need a Personal Line of Credit (LOC)? Aren’t they
basically the same thing? Not exactly, and understanding the key differences will be important
in determining which is the better option for you. Let’s run through three of the biggest
differences between Personal Loans and Lines of Credit:
1. How you Receive the Money
With a Personal Loan you
will receive the full amount that you’re approved for. So, for example, if you apply
for a $5,000 loan and are approved for that amount, you will receive that entire
amount upfront. This is pretty straightforward, although it is important to note
that you may not always be approved for the full amount you apply
for.
Various factors like your credit
score(Opens in a new
window) and your debt-to-income
ratio(Opens in a new
window) will impact the amount a financial institution will
approve you for.
A Line of Credit, on the other hand, provides a set amount
of money that you can draw from, or use, at any time. You may never need the money,
or you may access it regularly. You can draw any amount that you’d like as long as
it’s not more than the total amount you’ve been approved for.
Let’s say
you’re approved for a $5,000 Line of Credit. You can draw and use any amount up to
$5,000. It’s a bit like a credit card in that aspect, without the actual plastic
card. You can keep using and re-using the money available as often as you need it.
As you pay the money that you use back, that amount becomes available
again.
How you’re going to receive the funds is the first step in determining
whether a Personal Loan or a Line of Credit is a better choice for you. Now, think
about what the money will be used for.
2. What the Money Will be Used for
How you plan on using the money will be a big part of deciding if a Personal Loan or
a Line of Credit is a better option for you. Personal Loans provide you with a lump
sum amount, which makes them good options for known expenses. Lines of Credit, on
the other hand, give you the ability to use the money as you need it. That makes
them ideal for unplanned expenses.
Personal Loans give you a lump sum amount.
Because you receive the entire amount upfront, Personal Loans are a good option for
things like making a big purchase, consolidating debt or funding your
education.
► Personal Loans for big purchases
Personal Loans typically have lower interest
rates than credit cards, making them a more attractive option
when you have to drop a sizeable amount of money on a purchase. Plus, they’re what’s
known as a term loan, whereas credit cards are revolving. This simply means that
there’s a defined payoff date with a Personal Loan. This can be very helpful when
budgeting out your monthly payments.
► Personal Loans for consolidating debt
Consolidating multiple credit card payments into a single personal loan payment,
often referred to as debt
consolidation, can often help people manage debt that at first
feels insurmountable. With lower average interest rates than credit cards, Personal
Loans can potentially save you money. Plus, because you’re using a Personal Loan to
pay off the credit cards, you free up your credit capacity which can improve your
credit score.
Watch our quick video for an explanation of debt consolidation.
► Personal Loans for education costs
Once you exhaust your free and lower-cost funding options (scholarships, grants,
federal student aid), a Personal Loan may be able to help you fill any remaining
gap. You can use the funds from your Personal Loan for everything from books to dorm
room essentials. Don’t apply for more than you absolutely need, though, because
Personal Loans are financial obligations. Avoid putting yourself into debt for
anything other than necessities.
Lines of Credit give you money you can use as you need it.
Lines of Credit, because they don’t give you all the money upfront, are good options
for those “just in case” moments. Emergency car repairs, overdraft protection, and
even small ongoing projects are all good candidates for a Line of Credit.
► Lines of Credit for Emergencies
A Line of Credit can provide you with a little peace of mind in the event of an
emergency. Because the money is there and waiting, you can draw on it immediately
rather than having to wait for a loan or credit card approval. Interest rates tend
to be slightly lower than credit cards, too. And because you can transfer funds
directly into your Checking Account, you can easily pay for things like tow trucks
that may not accept cards.
► Lines of Credit for Overdraft Protection
Sometimes we goof and spend more money than we actually have in our Checking Account.
Sometimes, we have to. Whatever the reason, overdraft protection ensures that you’ll
still be able to pay by automatically pulling the funds from another source. For
example, if you swipe your debit card for a $50 purchase but only have $20 in your
Checking Account, your overdraft protection will pull the remaining $30 from another
account.
While you can establish your Savings Account as your overdraft
source, using a Line of Credit protects the money you’ve been setting aside. Opening
a Line of Credit for overdraft means you’ll be able to pay for items and maintain
the integrity of your Savings Account. It’s important to note that overdraft is
there for your protection, not as a free pass to purchase items you cannot currently
afford.
► Lines of Credit for Small Projects
If you have small ongoing projects that you will occasionally need to fund, a Line of Credit may be perfect for you. Rather than receive all the money upfront – and having to set it aside – drawing from a Line of Credit as you need funds can make managing the money a little easier. There will be a maximum amount you can apply for though, so if you have larger projects like home renovations you may want to look into a Home Equity product(Opens in a new window) instead.
3. Interest Rates on Personal Loans and Lines of Credit
The interest rates will differ on Personal Loans and Lines of Credit and, in addition
to how you receive the money and what it will be used for, may help you decide which
is the better option.
Interest rates on Personal Loans are typically lower
than those on Lines of Credit. This is simply because Lines of Credit are often seen
by lenders as a riskier type of loan. Because you receive all of the funds upfront
with a Personal Loan, though, you’ll be paying interest on that entire amount from
the get-go. With a Line of Credit, the interest rate will likely be higher, but you
only pay interest on the money you actually use. If you have a line of $5,000 but
only draw $1,000, you’ll only be charged interest on that $1,000. See the below
example.
This makes understanding how you’re going to use the money even more important.
If you know you’ll need a certain amount upfront, a Personal Loan may be a better
option as it will likely have a lower interest rate. If you’re not sure how much
you’ll need, though, or want an emergency fund, a Line of Credit may be a better
choice as you won’t be charged interest on the money you don’t use.
It’s
always a good idea to talk to your financial institution to help you determine if a
Personal Loan or a Line of Credit is a better option for you, but understanding how
you receive the funds, what the money will be used for, and the difference in
interest rates will give you a solid start.
Other Credit, Loans and Debt articles you may be interested in
- Couple applying for a personal loanCredit, Loans and Debt
Can I Spend My Personal Loan on Anything?
Can you really use a personal loan for anything? Just about. Here’s how personal loans work, why they’re often better than credit cards, and the 4 most common uses. - Couple looking concernedCredit, Loans and Debt
Does Refinancing Impact my Credit Score?
Ever thought about refinancing your car loan or mortgage? Then you’ve probably wondered what will happen to your credit score if you do refinance.