The best route to financial wellness is to create a budget that allows for a certain amount of your income to be put away in savings for a rainy day. That said, even rainy days can get expensive and catch us off-guard. Sometimes even the best-prepared person will find that they need an alternative option to handle certain financial needs. This might involve taking out a personal loan or a line of credit. Which is the best option?
The answer to that question may be different for each person and their individual needs and the factors surrounding their finances. Most people will want to opt for the choice that will be most cost-effective and flexible for their own situation. We’ll walk through the differences — and similarities — between a personal loan vs. a line of credit to help you make the best decision for your needs.
💡 Tip: Don’t forget to try to set aside an emergency fund to help with rainy days and unplanned expenses.
Personal Loan vs. Line of Credit: What’s the Same?
Applying & Qualifying
Both a personal loan and a line of credit have similar application processes. They are both considered credit, so the lender looks at each applicant’s credit history, current debt, and current income. These factors can be used to get more information about how likely you are to be able to pay back the money, and all of these factors may be used to either approve or deny an application.
Both types of borrowing also have similar credit requirements, though these may vary from lender to lender. The credit requirements may differ depending on where you go to get a personal loan or line of credit (online lenders, banks, credit unions, etc.), and each may also have other eligibility guidelines.
In most cases, you can expect that lenders will want you to have good or excellent credit to be approved for either a personal loan or a line of credit. The better your credit score, the more favorable the terms of the loan (i.e. interest rate) are likely to be.
Two Options: Secured or Unsecured
Both personal loans and lines of credit offer secured and unsecured options. Secured loans require collateral — an asset that “secures” the loan against default. If the borrower defaults on the loan, the lender can seize the asset. Many other types of loans are considered secure because they inherently include an asset. For example, an auto loan is secured with the vehicle the loan is used to purchase, and a home loan is secured with the house the loan is used to purchase. In both cases, the asset can be seized by the lender if the borrower fails to repay the loan.
Personal loans and lines of credit may also be unsecured, where a lender provides money without requiring collateral. With unsecured loans and lines of credit, the borrower can use the funds at their discretion. One example of a common unsecured line of credit is a credit card. If you fail to make payments on the amount you’ve borrowed, there is nothing for a lender to seize. Unsecured loans may be a more flexible option, depending on what you need the funds for.
Personal Loan vs. Line of Credit: What’s Different?
Despite the similarities, there are quite a few differences between a personal loan and a line of credit — differences you may want to carefully consider before making a decision.
Both lines of credit and personal loans require you to pay interest on the money you borrow; however, you will probably see higher interest rates with lines of credit than with personal loans. This is because lenders determine interest rates for lines of credit almost solely on your creditworthiness and income levels. Since interest rates for lines of credit are variable, the lender may also raise the rates after a person receives the money.
While personal loans may sometimes have variable interest rates, fixed interest rates are more common. This means that your interest rate does not change during the life of the loan. What’s more, interest rates on personal loans, in general, tend to be lower than those offered for lines of credit. Lenders also take many factors into account when determining interest rates for personal loans. The lender may consider the amount borrowed and the length of the loan in addition to creditworthiness, income levels, and debt-to-income ratios. Because of this, borrowers may have more flexibility in getting better rates.
How funds are paid out to the borrower is one of the main differences between personal loans and lines of credit. Personal loans payout the amount borrowed in one lump sum. The borrower receives the entire amount of the loan at one time.
Lines of credit are considered revolving credit, meaning the borrower can access the money as they need it up until they reach the credit limit. With lines of credit, even if a person is approved for a certain amount of credit, that doesn’t mean they need to use all of it.
Paying Back the Money
Repayment is set up differently for a personal loan than it is for a line of credit. Personal loans have a straightforward repayment process where the borrower must make regular (usually monthly) payments during the repayment terms specified in the loan.
Those repayment terms are set at the beginning of the loan process. The lender calculates the repayment amounts by calculating the balance and the interest earned and dividing that number over monthly payments for as long as the repayment period lasts.
Since a line of credit is revolving credit, the repayments are not calculated the same way because there usually isn’t a time frame within which the credit must be repaid. Instead, monthly payment amounts are calculated in a similar way that credit card minimum payments are determined, though each lender may have its own formula to determine monthly payments.
Understanding how personal loans and lines of credit work is the first step in making an informed decision that best suits your needs. Both options are solid ways to get cash when you need it, but it’s important to consider the differences in interest rates, repayment, and payouts to make a good decision.