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Line of Credit vs. Loan: What’s the Difference?
Loans often come with a lot of terms and stipulations regarding how you can use them; if you need something that offers a bit more flexibility and freedom, you might want to consider taking out a personal or business line of credit.
What is the difference between a line of credit and a loan, and which one is right for you? This guide will tell you everything you need to know.
How Does a Personal Line of Credit Work?
A line of credit is when you take out a fixed amount of money from a bank or lending institution. You can draw upon this money as needed to pay for different personal expenses.
In many ways, a line of credit (LOC) functions like a credit card. If you take out a line of credit for $50,000, but you don't use the money, you won't pay any interest. Let's say a few months later you use $10,000 to get a new car. You will then only need to pay interest on the $10,000. The repayment structure is also similar to a credit card. Each month the lending agency will send you a statement with your balance, interest summary, and minimum payment due. To remain in good standing and avoid the risk of having your LOC revoked, you will be expected to pay the minimum every month.
Secured vs. Unsecured
A line of credit can be taken out in one of two ways. Having a secured LOC entails using collateral, such as your home or business. These often come with lower interest rates because the lending institution can take over your property should you default on repayment.
An unsecured line of credit has higher interest rates because there the lender has nothing to seize should you be unable to pay back the line of credit. This type of LOC is often more challenging to obtain. When seeking an unsecured line of credit, you will need to show proof of exceptional credit.
Pros of a Personal LOC
There are many benefits for getting a personal line of credit, the most obvious being flexibility. This is across all areas of the borrowing process, including repayment, usage, and the amount.
With a credit line, you only borrow what you need, rather than being limited to a fixed amount. It's ideal for long-term projects or expenses where you are unsure of the final costs. It is also an excellent option for temporarily supplementing your funds during an unanticipated life event or emergency.
Getting your money is quick and easy. Once you are approved for a LOC, you will have unlimited access to your available funds. This allows you to use them as needs arise, rather than applying each time you need cash.
A line of credit is also a renewable source of funds. Going back to the car example, once you pay back the $10,000 you borrowed, you will once again have a $50,000 credit limit.
Cons of a Personal LOC
There are a few downsides when taking out a personal line of credit. Even with a secure line of credit, interest rates are often higher than you would get with a personal loan. They also tend to have variable rates vs. fixed Annual Percentage Rates (APR). Which means you could end up paying back more than you originally intended.
Accounts come with annual service fees, regardless of whether you are using the money or not.
In addition, they aren't the best option for people with poor spending habits as they allow flexibility for overspending. Although they can be used as a short-term cash supplement, this is often a dangerous line to walk and unsuitable for achieving long-term financial stability.
Personal Line of Credit vs. Loan
Loans and credit lines are types of debt issued by banks or lending agencies. Both loan and line of credit types depend upon the intended use, your financial standing, and credit history. Your relationship with the lending institution will also play a role in what is available to you.
Loans are granted for one-time usage and have a fixed repayment term, whereas lines of credit can be used when and how you please. With credit lines, lending agencies monitor your usage and credit status. If you haven't used your LOC in some time, they could reduce or close it.
Like LOCs, loans can be secured or unsecured. All personal loans are unsecured because they are not backed by collateral. In contrast, a home or car loan is classified as a secure loan and often includes stipulations on how you can and cannot spend money.
If you take out a home loan for $500,000 but only end up using $450,000, you won't be able to spend the other $50,000 getting a new car.
A personal loan provides the freedom to use the money as you see fit. However, since you have to take the entirety of the loan at once, you will be incurring fees from day one. Even if most of the money is sitting in your bank account waiting to be used, you will be expected to pay the minimum principal and interest fees every month.
With a line of credit, you will have a bit more freedom and only pay fees on what you use. Even a secure line of credit is not linked to a specific purpose and is great for everyday use and unexpected emergencies.
When to Apply for a Personal Line of Credit
There are three primary reasons to apply for a personal line of credit vs. a loan.
1. You're not sure how much money you'll need
Sometimes, you might not be able to predict how much everything is going to cost. A personal line of credit gives you the financial flexibility to use what you need rather than being tied down to a specific amount. They are also a great way to consolidate your debt.
2. Your expenses may be spread out over the years
You might have many different expenses coming up, such as home improvement projects or a significant life event like a wedding. A line of credit is something that you can access over and over. Use it for one expense, pay it off, and have the entire amount ready for the next thing life throws your way.
3. Your credit is in good condition
If you plan to apply for an unsecured personal line of credit, it is vital to have good credit. Having bad credit will affect your ability to get approved and leave you paying steep interest rates.
When to Apply for a Personal Loan
Depending on your situation, getting a personal loan might be the better option. Here are two reasons to consider getting a loan.
1. You know how much you need to borrow
Let's say you have hired a company to remodel your kitchen. You know exactly how much everything will cost and have no other expenses coming up that require extra cash. Loans come with more flexibility in how much you can borrow at once and lower repayment rates.
2. You want to limit the amount of debt you take on
If you know that you tend to overspend when money is available, a loan might be the better option. The money focuses on one expense versus allowing flexibility which could lead to additional spending. Loans also tend to have fixed interest rates and less of an immediate impact on your overall credit score.
Business Line of Credit vs. Loan
A business line of credit is very similar to a personal line of credit. The main difference is that it is intended for short-term needs. You can use a business line of credit as needed, so long as you faithfully pay your monthly minimum and any associated annual fees.
Business LOCs are an excellent option for startups that need to have flexibility regarding cash flow. If your business is already established and you're looking for a more extensive credit line, you can put up collateral to get a secured line of credit. This might include business real estate, additional fleet vehicles, or inventory.
One business line of credit and loan difference is a loan is designated for a specific purpose. Long-term loans are geared towards investments and other expenses that take time, such as an office remodel. Short-term business loans have a quick repayment schedule and are intended for immediate needs, such as building up inventory.
When You Should Apply for a Business Line of Credit
There are a few factors to consider when applying for a business line of credit vs loan.
1. You need ongoing access to cash
If your business is going through a stage of change—expansion, redesign, or restructuring—you might need to access cash with some irregularity. New expenses and unexpected costs can throw off your normal budget. A line of credit will provide you with peace of mind, knowing the cash is there should you need it.
2. You need payment flexibility
With a business line of credit, you will only need to worry about repaying the minimum each month. This is different from a loan where you have a principal in addition to interest and a fixed repayment term. A business LOC gives you the flexibility to focus on your business now and worry about complete repayment later.
When You Should Apply for a Business Loan
Business loans can be the preferred choice depending on your company's needs and stage of development.
1. You know how much you need to borrow
Perhaps you are adding a new real estate holding to your business. Since you don't require regular access to additional funds, a business loan might be the better route. Your interest rates will often be lower, and you won't have to worry about the annual fees associated with a LOC.
2. You want to have set repayment costs
Business loans often come with a fixed APR. You can choose your repayment term, so you know what you're paying overtime. This is extremely helpful when trying to budget for your business.
How to Apply for a Personal Line of Credit
You will need two things when you apply for a personal line of credit: your credit history and a solid credit score. Beyond that, the application process is very similar to applying for a personal loan.
Take some time to consider which lender to borrow from. Look into their rate structure, annual fees, and lending limits. How much you can borrow will depend heavily on your credit score.
Once you've decided on a lender, it's time to fill out the application. Many lenders will allow you to apply online or even over the phone. Once you have been approved for a line of credit, your funds will be accessible in as little as one business day.
Should I Get a Loan or Line of Credit?
Deciding whether to get a line of credit vs. a loan depends on why you need the money and how you intend to use it. There are pros and cons to each, including different interest rates, accessibility, and spending freedom.
If you are looking at long-term flexibility and unknown costs, a line of credit is a good option for you or your business. For those who know exactly where the money is going and need a stable and fixed repayment option, a personal or business loan is often the better option.
Joseph Priebe takes pride in assisting audiences with his articles to help them make sound financial decisions.
With over ten years of experience writing financial content his goal at CASH 1 has always been creating engaging and easy-to-digest information for anyone searching for immediate or long-term monetary solutions.
When Joseph is not writing about personal finance, you can find him photographing the Southwest United States with his 4x5 Graflex Crown Graphic camera. He is based in Phoenix, Arizona.