Personal Loan vs Line of Credit
For just about everyone, there’s going to come a time when you need to borrow a substantial amount of money. When that happens, what are your best options? Do you take out a line of credit or a personal loan?
You’re not alone if you’re faced with this dilemma, as there’s plenty of borrowing going on; in fact, the financial industry, which is built on lending and insurance products, represents more than 7% of the U.S. economy and generates $1.5 trillion per year.
You’re also not alone if you’re confused about which options to pursue. However, it’s important to understand what a personal loan is, what a personal line of credit is, how to apply and how to pay it back without penalties.
|Lender||Draw Period||APR||Line Min.||Line Max.||Annual Fee|
|SunTrust||4 years||Prime Rate+1.99% to +4.49%||$25,000||$250,000||$0|
|Santander Bank||5 years||8.99%–18.00%||$5,000||$35,000||$0-$50|
What is a Personal Loan?
Personal loans come in two forms: secured and unsecured. With a secured loan, a borrower must have some kind of collateral in order to be approved. Most lenders, particularly traditional banks, prefer that collateral to be liquid or easy to liquidate.
For example, a lender may ask a borrower to put up the funds in a money market account, certificates of deposit, or bonds. If there are no banking products to put up, the lender will consider real estate and high-value possessions. When borrowers default on a secured loan, the lender seizes the asset and sells it.
With an unsecured loan, a borrower doesn’t use collateral at all. Borrowers are pre-approved for personal loan rates according to repayment history, income and credit score. Without collateral, lenders take on more risk and therefore charge more interest on unsecured loans.
In recent years, the unsecured loan industry has exploded. Online lenders, in particular, have started offering unsecured personal loans to borrowers who would otherwise not be able to obtain them. When borrowers default on an unsecured loan, the lender doesn’t have collateral to seize. Instead, they pursue debt collection and legal action to recoup the funds.
- One lump sum funded to account
- Lower interest rates
- Strict repayment schedule
- Collateral at risk of seizure
What is a Personal Line of Credit?
A personal line of credit lets you borrow up to a maximum amount and use the funds on an as-needed basis. Once the withdrawn funds are paid back, you can use the funds up to the same maximum amount. This incremental borrowing and repayment cycle can continue up until the end of the line of credit’s draw period.
In this way, a line of credit is not unlike a credit card. Two benefits it has over credit cards are the lack of fixed monthly payments and the more favorable interest rates.
There are downsides, though. It’s important to note that, with lines of credit, the interest kicks off as soon as you borrow. The interest rate will typically be variable but based on The Wall Street Journal‘s Money Table Rates. You also face possibly devastating financial losses if you cannot pay back the line of credit. This could seriously impact your credit score and deter most lenders from providing you with reasonable loan rates in the future.
- Only borrow and pay back what you need
- Flexible repayment schedule
- Credit score at risk if you default
- Limited draw periods
Personal Loan vs Line of Credit
In essence, a personal loan hands over a quantity of money to the borrower. That borrower pays back the loan in monthly installments. There’s no additional funding built within the loan terms. There’s no ability to free up new money.
Traditional banks tend to offer secured loans, requiring collateral. Online lenders tend to offer unsecured loans, meaning no collateral and sometimes high interest rates based on the borrower’s creditworthiness and repayment history.
A line of credit is also unsecured. Banks and online lenders base their terms on the borrower’s creditworthiness. If your credit score is high and you’ve had no problems paying off debts in a timely fashion, you’ll be approved to borrow money on an as-needed basis over the course of several years.
Once you spend some of the funding, you have to repay it in order to access all of the available credit. Moreover, once the line of credit’s draw period ends, you cannot access any of the credit.
When to Use a Personal Loan
Let’s say you need a quick and substantial cash infusion, but you don’t plan to need more cash after that one-time payment. Your situation could be remedied with a personal loan, which will likely have a lower interest rate than a personal line of credit. Maybe you have excellent collateral, like bonds, a money market account, or high-value possessions. That provides ideal circumstances for an unsecured loan.
What if you don’t have anything to put up, but you have a killer credit score and a spotless repayment history? In that case, you might qualify for personal unsecured loan rates, which can be surprisingly reasonable if you meet the aforementioned conditions. Weddings, medical bills and travel are all great examples of when to use a personal loan. You only need a lump sum for the major purchase, and you have the ability to repay without issue.
When to Use a Line of Credit
Imagine you bought an investment property — a real fixer-upper. It presents an unmatched income-producing opportunity, but first it needs some serious work.
You’ll need some up-front capital to buy the property, but what you’ll really need is ongoing funding to renovate, remodel, paint, landscape, design and stage. Due to the nature of the investment, you’re uncertain as to exactly how much you’ll need and when. You do know you’ll need access to funds over the course of several years, however.
This kind of situation is perfect for a line of credit: capital, money as needed and a long draw period. Lines of credit operate much like a credit card, minus the physical card, but they have much better interest rates and repayment terms.
The Final Word
A line of credit could ultimately cost you more money as a borrower. The interest rate will be substantially lower than what you’d get with a credit card, but it will likely be higher than that of personal loan.
That being said, lines of credit and personal loans offer dramatically different benefits. A personal loan gives you a one-time lump sum. Then you pay a fixed amount every month until you’ve repaid the loan. A line of credit gives you access to ongoing funding up to a maximum, predetermined amount. You pay it back what you borrow, freeing up that money for you to borrow again.