As the song goes, “We all need somebody to lean on.”
We also need money sometimes, and that can come in the form of a personal loan or a line of credit.
These two credit options have a lot in common, but you should know the difference if you want to make a cost-effective decision that meets your needs.
What’s a personal loan?
A personal loan is a structured, set amount of money you can borrow. You get the money upfront in a lump sum, and lenders typically set a minimum on how much money they give in a personal loan, which makes smaller amounts more difficult to attain.
When you take out a personal loan, you agree to repayment terms that dictate how much you pay back every month for a set amount of time. If you miss a payment, you may be charged punitive interest fees.
These are the three things that most affect the terms of a personal loan:
- Your personal financial profile
- How much money you borrow
- How many months you need to repay
What’s a line of credit?
A personal line of credit is similar to a credit card. Often called “revolving credit,” a line of credit allows you to access to cash as you need it, instead of upfront in a lump sum. With it, you have access to the amount of money you need, though there is a set limit.
However, repaying a line of credit is different from a personal loan.
Once you begin using your line of credit, it’s best to pay it back as quickly as possible to avoid possible interest charges. But it’s not as structured as repaying a personal loan.
Each lender’s terms are different, and it’s important to read the fine print to know exactly what you can and cannot do. In general, repaying a line of credit is like repaying a credit card.
But revolving credit also doesn’t have an end. So if you’re working on a project with an uncertain end-date, you can use this form of capital to ensure you get it all done without having to apply for a new loan. Also, you’ll only have to pay interest on the amount you actually borrow. So if a project comes in at a lower amount than you expected, you won’t be on the hook for the difference.
What’s the difference?
The biggest differences between a personal loan and a line of credit are in how you receive the money (lump sum vs. revolving) and how you repay (structured vs. as-you-go).
But there are differences in how they’re set up, too.
A line of credit typically has a higher interest rate. How much you pay in interest is decided by the factors that affect your ability to borrow money: credit score and income.
The rate on a line of credit is often variable, which means the lender can change the rate after you’ve opened up the line of credit. A line of credit is often easier to attain, as well.
A personal loans is more likely to have a fixed rate, though a variable rate is possible. They’re also tougher to secure for people with less-than-stellar credit.
Your credit history and income are important factors if you’re interested in a personal loan or a line of credit — lenders use them to determine your interest terms.
Personal loans and lines of credit can be secured or unsecured. If it’s secured, you must provide some form of collateral, like property or a car.
Is a personal loan right for me?
A personal loan is usually a good idea if you know exactly how much money you need.
For example, if you already have a bill and know that’s all you need to pay.
Other situations where a personal loan might help:
- Auto repairs
- Unexpected medical costs
- Big-ticket purchases (e.g. a new car)
- Credit card balances
- Tax bills
Is a line of credit a better option?
A line of credit is ideal if you don’t know exactly how much money you need.
If you have ongoing expenses, for example, or if you aren’t sure when your next big payday will arrive, a line of credit can provide stability.
A few times when a line of credit could help:
- Weddings (unexpected costs often arise)
- Home renovations
- Ongoing medical costs
- Unpredictable income (contract workers or commission-dependent salespeople)
Bottom line: If you need to borrow money, you have reliable options in either a personal loan or a line of credit. A personal loan is more rigid, but usually has a better interest rate. A line of credit offers more flexibility, but you need to be smart about repaying it.