- Personal loans and lines of credit are two ways to raise cash for just about any purpose.
- A personal loan pays you the full amount up front and can be good when you know how much you need.
- If you plan to use cash as the need arises and aren’t sure of the total amount, a line of credit might be best.
There are all sorts of loans tailored for specific needs in life, like paying for college, financing a new car, or purchasing a home. When you need money for reasons that don’t fit into any of these specific categories, a personal loan or line of credit can be a good option.
“Personal loans and lines of credit both provide two different ways to reach the same end goal — borrowing money,” says Dani Pascarella, a CFP® professional and Founder of OneEleven Financial Wellness.
You can use the money from a personal loan or line of credit for just about anything.
Personal loan vs. line of credit: At a glance
While both options are available if you need to borrow money, there are key differences in the way personal loans and lines of credit are obtained and used.
- Personal loans are lump-sum installment loans that you can use for any purpose, like paying for an emergency expense, a home appliance, or even consolidating debt.
- Lines of credit are allow you to borrow and make payments on an ongoing basis. You can borrow up to a maximum amount for which you’re approved based on your credit history.
What is a personal loan?
With a personal loan, you receive the approved amount in one lump sum and then make monthly payments until you’re paid in full. Those payments include the principal amount or the amount you borrowed, along with interest.
When applying for a personal loan, key things to consider include:
- Credit and income requirements
- Interest rates
- Fees (if any)
- Terms, including how long you have to pay it back
“A personal loan makes sense when you know how much money you need to borrow,” Pascarella says. “Borrowers like this approach because there is a clear end date when this debt will be paid in full, and the fixed monthly payments make the loan easy to add to a household budget.”
Personal loans are usually unsecured, which means the biggest determining factor in approval is your credit score. The higher your credit score, the more likely you are to get approved at the lowest interest rate available. For bad and fair credit borrowers, you may have a harder time getting approved and if you do, it might be for a higher interest rate.
If you’re having trouble qualifying for an unsecured personal loan, there are some banks that offer secured ones. Secured personal loans are backed by collateral just like other types of secured loans, but for personal loans, they’re a bit different. They’re backed by your savings accounts or certificate of deposit(CD) account. Your loan will usually be a percentage of the account balance, which is determined by the bank or financial institution you go with.
Interest rates for personal loans are usually lower compared with lines of credit, but it comes down to your creditworthiness and how responsible you are as a borrower to prove you should get the lowest interest rate offered.
When is a personal loan better than a line of credit?
A personal loan might be better than a line of credit if:
- You know specifically how much you need. If you have a specific goal in mind, like buying a new appliance or paying off outstanding medical debt, a personal loan might be what you need to cover your expenses.
- You want to make consistent monthly payments. Personal loans tend to have fixed interest rates, which means you’ll pay the same amount every month for the life of the loan. If you’re on a strict budget with very little wiggle room, a personal loan might be a better option.
- You’re consolidating debt. If you have a lot of outstanding debt with high interest rates, you can consolidate it with a personal loan. You’ll borrow the full amount you want to pay off. When you get the money in a lump sum, you’ll pay off all your debt and then make a single monthly payment to your new lender.
Example of a personal loan
Let’s say you’re planning a wedding reception, and the venue needs half of the costs up front. While you might’ve saved a little bit for your big party, you may not have enough to cover the big, one-time expense. You can take out a personal loan to cover the venue deposit and then make manageable monthly payments to repay it.
What is a line of credit?
A line of credit is a flexible funding option you can use if you need revolving access to cash.
With a line of credit, your lender determines the maximum amount you’re qualified to borrow. Then you can borrow as little or as much as needed, up to the maximum. In most cases, if you pay the balance off in full by your monthly due date, you can avoid paying interest. You’ll need to make minimum monthly payments to remain in good standing. You pay interest only on the amount you borrow — not the full amount you’re approved for.
Most lines of credit are unsecured, which means you don’t need collateral. A credit card is a good example of this. Lenders use your credit history, credit score, and other factors to determine how much you can borrow and at what interest rates. However, some lines of credit, like home equity lines of credit (HELOCs), are secured, using your home as collateral.
Personal lines of credit have a draw period, where you can borrow as needed and begin to make payments. Then there’s a repayment period during which you can’t borrow anymore until the balance is paid in full. Credit cards let you borrow up to the maximum amount for which you’re approved. If you reach that limit, you can’t borrow any more until you make payments that reduce the principal balance.
“If you are looking for flexibility on how much you borrow, when you borrow those funds, or your repayment plan, a personal line of credit is a good choice,” Pascarella says. “You can also repay the debt in your desired time frame as long as you meet minimum monthly payments.”
When is a line of credit better than a personal loan?
A line of credit is a good idea if:
- You aren’t sure how much money you’ll need. If you have a vague idea of how much you want to borrow but think you may need more, a line of credit gives you the option to use more when you need it.
- You can pay in full. Interest rates for personal lines of credit and credit cards tend to run higher, on average, than those for personal loans. Interest rates are applied when you carry a balance from month to month, so if you pay off your balance in full by the due date, you can essentially borrow interest-free.
- You want to use it long-term. Lines of credit can be kept for many years. For personal lines of credit, that could be around 15 years, while you can maintain credit card accounts for decades. If you want the option to draw from the account for many years to come, a line of credit is a better choice.
Example of a line of credit
Let’s say you’re getting married and, aside from a large venue deposit, your florist and caterer also need deposits for the big day. With many expenses coming up at once — and some you aren’t sure about — you can use a personal line of credit to transfer money to your bank account and make your deposits on time.
You can also use a credit card to cover minor expenses throughout the wedding planning process or to make a large purchase that has generous cashback offers. For instance, you may use a travel credit card to book the honeymoon and in the process, you earn a free flight through the points you’ve earned.