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 and your debt-to-income ratio 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 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.
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