Which works better? A line of credit or personal loan? The answer is always in the details.
With the number of financing options available today, it can be very confusing finding the product that is right for you. It can even prove difficult deciding between two basic personal finance options – personal loans or lines of credit. Each has its own advantages and disadvantages and making the wrong choice could be very expensive. Choosing the most appropriate option for your particular situation could potentially save you thousands in interest repayments and fees.
The main points of difference
- Loan term. Personal loans have a fixed term of anywhere between one and seven years, and need to be paid back in full by the end of that term. Lines of credit don’t come with a “term” and the funds you borrow become available again after they’re repaid (plus interest).
- Repayments. Both involve monthly repayments. However, personal loans have fixed monthly repayments while lines of credit depend on the previous balance, amount drawn, accruing interest and other factors.
- Time of disbursement. With personal loans, your lender will disburse your funds up-front as soon as you agree on the loan contract and sign it. With a line of credit, you’re able to withdraw up to your approved limit on an ongoing basis as long as you’re meeting minimum monthly repayments
- Fees. Personal loans usually charge monthly service and application fees while lines of credit usually charge annual service fees. However, lenders for both personal loans as well as lines of credit may charge a variety of other hidden fees. Make sure you’re aware of all fees for any option you’re considering.
Compare personal loans and lines of credit
Features of personal loans and lines of credit
Personal loans provide your funds up-front and stipulate an agreed time period to pay back your loan (called the “loan term”). Interest is charged on the entire duration of your loan term and on your entire loan amount. In general, most personal loans involve the following features:
- Up-front lump-sum. Once the lender approves your application and you agree to the loan contract, you’ll receive all your funds up-front.
- Interest rate. Your lender will charge either a fixed interest rate that won’t change over the term of your loan, or a variable interest rate which can rise or fall depending on market rates.
- Term. The period over which you’ll be making repayments to fully pay back the loan is called the loan term. It generally ranges between one year and seven years.
- Discount rates. Your lender may offer you a limited time discount if you take out a significant loan amount.
- Flexible repayments. Depending on your lender, you may be able to choose exactly how you’ll be making monthly repayments.
Line of credit
Lines of credit have a maximum credit limit and you’ll only be charged interest on the funds you actually use. Repayments are made monthly but there is no fixed “term” for a line of credit. As long as you’re making your minimum monthly repayments, your funds will always be available to you.
- Option to increase maximum credit limit. Your lender may provide an option to increase the maximum credit limit in line with your specific needs.
- Flexible withdrawals. You’ll be able to withdraw funds from your line of credit whenever you like, as long as it doesn’t exceed your maximum credit/daily limit.
- No fixed repayments. As long as you’re making a minimum required monthly payment (a percentage of withdrawn funds), there’s no fixed repayment amount.
- Interest rate. Interest is paid monthly and is only charged on the amount you have used.
Which is suited to you?
A personal loan is suited to someone who wants structured repayments and an initial lump sum paid to them at the beginning of the loan term. A personal loan is well suited for those looking to make large purchases such as for a wedding or car using that lump sum. A personal loan can also be appropriate for those looking to consolidate a large amount of debt.
A personal loan may also be better-suited for those who are generally unable to pay their monthly credit card balance in full since not doing so for lines of credit could get very expensive.
Lines of credit are helpful for those needing ongoing sources of funding to be used when they see fit. Since lines of credit are revolving, you won’t be charged on funds you don’t use, making them an excellent option as a backup source of funding.
Since interest rates could get expensive for lines of credit, they are suited to those looking for flexibility with their credit and an ongoing source of funds for purchases such as paying bills, consolidating short-term debt and shopping.
Questions to ask to find the right loan for you
While it will depend on your particular situation, you can get a clearer picture of your decision by asking yourself the following questions:
What do you need the funds for?
If you’re looking to use the funds for large purchases, you’d probably be better off with a personal loan. If you want an ongoing source of funding then a line of credit would be more suitable.
How flexible are you with repayments?
Whichever option you consider, make sure you’re well aware of how disciplined you’ll need to be with repayments. Some people are tempted to use a line of credit simply because it’s there. If this could be a problem for you, you may be better off with the structured features of a personal loan since they offer fixed-repayment schedules, giving you consistency and balance.
How much do you need?
Unsecured personal loans may offer about $55,000 while secured personal loans would depend on the worth of the collateral you offer up as security, but can be as much as $80,000. On the other hand, not many lenders approve small amounts for personal loans but do so for lines of credit. Very large lines of credit are also available, but you’ll need to meet strict eligibility criteria.