- Personal loans and lines of credit are two ways to raise funds for just about any purpose.
- A personal loan pays you the full amount up front and can be beneficial when you know how much you need.
- If you plan to use cash as needed and are unsure of the total amount, a line of credit may be preferable.
There are all kinds of loans tailored to specific life needs, like paying for college, financing a new car, or buying a house. When you need money for reasons that don’t fit into any of these specific categories, a personal loan or line of credit can be a good option.
“Personal loans and lines of credit offer two different ways to achieve the same end goal: to borrow money,” says Dani Pascarella, CFP® professional and founder of OneEleven Financial Wellness.
You can use money from a personal loan or line of credit for just about anything.
Personal loan vs line of credit: in brief
Although both options are available if you need to borrow money, there are key differences in how personal loans and lines of credit are obtained and used.
- Personal loans are lump-sum installment loans that you can use for any purpose, such as paying for an emergency expense, a household appliance, or even consolidating debt.
- Lines of credit allow you to borrow and make payments on an ongoing basis. You can borrow up to a maximum amount that you are approved for based on your credit history.
What is a personal loan?
With a personal loan, you receive the approved amount in one payment and then make monthly installments until you are fully repaid. These payments include the principal amount or the amount you borrowed, plus interest.
When applying for a personal loan, the main things to consider are:
- Credit and income requirements
- Interest rate
- Fees (if applicable)
- Terms, including how long you have to pay it back
“A personal loan makes sense when you know how much money you need to borrow,” says Pascarella. “Borrowers like this approach because there’s a clear end date when that debt will be fully paid off, and the fixed monthly payments make the loan easy to add to a household’s budget.”
Personal loans are generally unsecured, which means that the main deciding factor in approval is your credit score. The higher your credit score, the more likely you are to be approved at the lowest interest rate available. For bad and fair credit borrowers, you may have a harder time getting approved and if you do, it could be for a higher interest rate.
If you are having difficulty qualifying for an unsecured personal loan, some banks offer secured loans. Secured personal loans are collateral-backed just like other types of secured loans, but for personal loans they are a little different. They are backed by your savings accounts or your certificate of deposit (CD) account. Your loan will usually be a percentage of the account balance, which is determined by the bank or financial institution you go with.
Personal loan interest rates are generally lower than lines of credit, but it depends on your creditworthiness and responsibility as a borrower to prove that you should get the lowest interest rate available.
When is a personal loan better than a line of credit?
A personal loan may be preferable to a line of credit if:
- You know exactly how much you need. If you have a specific goal in mind, like buying a new device or paying off an outstanding medical debt, a personal loan might be what you need to cover your expenses.
- You want to make regular monthly payments. Personal loans tend to have fixed interest rates, meaning you’ll pay the same amount each month for the life of the loan. If you have a strict budget with very little wiggle room, a personal loan might be a better option.
- You are consolidating debts. If you have a lot of unpaid debts with high interest rates, you can consolidate them with a personal loan. You will borrow the full amount you wish to repay. When you receive the money in a lump sum, you pay off all your debts and then make a single monthly payment to your new lender.
Example of personal loan
Let’s say you are planning a wedding reception and the venue requires half of the initial costs. While you may have saved a little for your big party, you may not have enough to cover the big one-time expenses. You can take out a personal loan to cover the room deposit and then make manageable monthly payments to pay it off.
What is a line of credit?
A line of credit is a flexible financing option you can use if you need revolving access to cash.
With a line of credit, your lender determines the maximum amount you can borrow. Then you can borrow as little or as much as needed, up to the maximum. In most cases, if you pay off the entire balance before the monthly due date, you can avoid paying interest. You will need to make minimum monthly payments to stay in good standing. You only pay interest on the amount you borrow, not the total amount you are approved for.
Most lines of credit are unsecured, which means you don’t need collateral. A credit card is a good example. Lenders use your credit history, credit score and other factors to determine how much you can borrow and at what interest rates. However, some lines of credit, such as home equity lines of credit (HELOCs), are secured, using your home as collateral.
Personal lines of credit have a drawdown period, during which you can borrow as needed and start making payments. Then there is a repayment period during which you cannot borrow again until the balance is paid in full. Credit cards allow you to borrow up to the maximum amount you are approved for. If you reach this limit, you can’t borrow any more until you make payments that reduce the principal balance.
“If you’re looking for flexibility in how much you borrow, when you borrow those funds, or in your repayment plan, a personal line of credit is a good choice,” says Pascarella. “You can also pay off the debt on your desired schedule, provided you meet the minimum monthly payments.”
When is a line of credit better than a personal loan?
A line of credit is a good idea if:
- You don’t know how much money you will need. If you have a vague idea of how much you want to borrow, but think you need more, a line of credit gives you the flexibility to use more when you need it.
- You can pay in full. Personal lines of credit and credit card interest rates tend to be higher, on average, than personal loans. Interest rates are applied when you carry a balance month-to-month, so if you pay off your balance in full by the due date, you can essentially borrow without interest.
- You want to use it long term. Lines of credit can be held for many years. For personal lines of credit, this could be around 15 years, while you can keep credit card accounts for decades. If you want the ability to withdraw from the account for many years, a line of credit is a better choice.
Example line of credit
Suppose you are getting married and, apart from a large deposit, your florist and caterer also need deposits for the big day. With many expenses coming up at once — and some you’re not sure about — you can use a personal line of credit to transfer money to your bank account and make your deposits on time.
You can also use a credit card to cover minor expenses throughout the wedding planning process or to make a major purchase with generous cashback offers. For example, you can use a travel credit card to book the honeymoon and by doing so you will earn a free flight with the points you have earned.