For many people, there comes a time when you need to borrow money to cover your expenses. Maybe you're financing a major home renovation, covering medical costs or sending someone to college. Whatever the case, a personal loan and line of credit are two options that can give you the money you need.
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Below is an explanation of the differences between these two financial products, some examples of when it’s best to use each one, and an overview of how to apply once you’ve made your decision. Keep reading and learn how these products can help bring a sense of security into your financial life.
What’s the difference between a personal loan and line of credit?
Disbursement of the loan
One of the biggest differences between a personal loan and line of credit is in how the funds are disbursed. With a personal loan, the money is given to you in one lump-sum. However, a personal line of credit works more like a credit card. In this case, you can borrow money as needed, up to a certain limit.
Another difference is in how interest is calculated on the borrowed funds. With personal loans, you’re typically given a fixed interest rate and the rates are usually lower than those for personal lines of credit. With a personal line of credit, on the other hand, the interest rate is typically variable, which means that it can change after you’ve borrowed the money.
The last major difference between personal loans and personal lines of credit comes down to how repayment works. If you take out a personal loan, you’ll be expected to make fixed, monthly payments for a set period of time, similar to a mortgage payment.
In contrast, repayment on a personal line of credit is similar to a credit card, where you can choose how much you pay off, as long as you cover the minimum payment. How that minimum payment is calculated can vary by lender, but it’s typically either a set minimum fee or a percentage of what you’ve borrowed.
How to apply for a personal loan or personal line of credit
No matter which option you choose, the application processes for personal loans and personal lines of credit are very similar. In both cases, the lender will look at your credit score, income and assets to determine if you’ll be approved.
The big difference in this case is between secured and unsecured borrowing. Both personal loans and lines of credit come in either form.
With secured debts, you have to put up an asset as collateral, meaning that, if you default on the loan, your lender can take that asset as a form of repayment. For example, your vehicle serves as collateral for your car loan and your home is collateral for your mortgage.
In contrast, with unsecured debts, you don’t have to put up any collateral. Instead, your eligibility for one of these loans is determined entirely by the strength of your credit score and your financial profile. However, since the lender has less reassurance of repayment with unsecured debts, these options often come with higher interest rates.
Personal loans and lines of credit: When to use each one
As for how to decide between a personal loan and personal line of credit, James Lambridis, CEO of DebtMD, a fintech startup based in Wayne, NJ, said:
“A personal loan is best for financing a purchase that will have a known, fixed cost. On the other hand, a line of credit is best when you are not sure how much money you will need to borrow.”
With that in mind, below are a few scenarios where you might use each one:
When to use a personal loan
- Consolidation of other debts like student loans
- One-time expenses like a car repair or a one-off bill
When to use a personal line of credit
- Ongoing medical expenses
- Education costs
- Home renovations