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Business News/ Money / Personal Finance/  Personal Loans vs. Lines of Credit: What's the difference?

Personal Loans vs. Lines of Credit: What's the difference?

Deciding between a personal loan and a line of credit hinges on your individual needs. The optimal choice is based on your financial circumstances and borrowing tendencies.

Understanding the difference between a personal loan and line of credit.Premium
Understanding the difference between a personal loan and line of credit.

Personal loans are occasionally referred to as signature loans, while lines of credit operate more like credit card accounts. Despite the confusion among modern borrowers, these two financial products have significant differences in terms of their features and everyday usage.

Understanding personal loans

A personal loan is an unsecured debt that you can obtain from a bank, credit union, or online lender. It involves borrowing a sum of money that you must repay with interest within a specified timeframe. Below are the main features of personal loans:

Unsecured: In contrast to auto loans or mortgages, personal loans do not necessitate collateral. Therefore, you are not required to use an asset such as a car or home as a guarantee for the loan.

Fixed rate and duration: Personal loans feature a fixed interest rate and a set repayment period, usually ranging from one to seven years. This results in consistent monthly payments throughout the loan term.

Single disbursement: Upon approval, you receive the full loan amount in one single payment.

Versatile use: Personal loans provide flexibility in how you can utilize the funds. Typical purposes include debt consolidation, home renovations, unforeseen expenses, or significant purchases.

What is a line of credit?

A line of credit (LOC) is a versatile borrowing solution provided by banks and other financial institutions. Similar to a credit card, you are granted a specific amount of money, known as a credit limit, which you can access. However, unlike a credit card where you receive the full amount immediately, with an LOC, you can withdraw funds as required, up to your set limit.

Here's an overview of how lines of credit operate:

Approval: You apply for a line of credit like applying for a loan. The lender evaluates your creditworthiness and establishes a credit limit based on their assessment.

Borrowing: Upon approval, you can access the funds via a check, debit card, or transfer. Interest is applied only to the amount you borrow, not the full credit limit.

Repayment: As you repay the borrowed amount, your available credit is replenished. You can keep borrowing from the line of credit as long as you remain within the credit limit and make your minimum payments punctually.

Lines of credit are primarily categorized into two types: Secured and unsecured. Secured lines of credit are supported by collateral, such as your home, which can lead to a reduced interest rate. On the other hand, unsecured lines of credit do not necessitate collateral but usually come with higher interest rates.

Interpreting the distinction

Depending on your circumstances, either a personal loan or a line of credit could assist you in achieving your objectives. Although both financing options may provide you with the necessary funds, they operate in distinct ways. Here's an analogy to clarify the distinction:

Consider a personal loan like borrowing a set amount from a friend. You take out a fixed sum and commit to paying it back with interest within a designated time frame. Picture a line of credit as similar to a credit card with a spending cap. You can utilize the funds as required, but interest is charged only on the amount you use, and you are obligated to make minimum payments.

If you require a consistent payment schedule and a fixed sum of money, a personal loan would be the better choice. On the other hand, if you need continuous access to funds and flexibility, a line of credit would be more suitable.

Deciding between a loan and a line of credit

Choosing between a personal loan and a line of credit depends entirely on your requirements. Here's a summary to assist you in making a decision:

A line of credit is a suitable choice if:

  • You require flexible access to funds for ongoing expenses or unforeseen emergencies.
  • You intend to borrow only a portion of the available amount and prefer to pay interest solely on the utilized sum.
  • You aim to manage your borrowing wisely. Responsibly using lines of credit can aid in improving your credit score.

Conversely, a personal loan might be more appropriate if:

  • You require a consistent repayment schedule with set monthly payments.
  • You need a one-time lump sum for a particular purpose, such as debt consolidation or a significant purchase.
  • You wish to secure a fixed interest rate for the duration of the loan.

Ultimately, the optimal choice depends on your financial circumstances and borrowing tendencies. Grasping the distinction between these two financial products can greatly assist you in selecting the option that suits you best.

Frequently Asked Questions

How does a line of credit function?

After approval, you can withdraw funds using different methods offered by the lender, like checks, debit cards, or online transfers. You are only required to pay interest until you hit your credit limit or decide to close the account. Typically, there are minimum monthly payments due on the remaining balance.

What kind of interest rates can one expect with a line of credit?

Interest rates for lines of credit are usually variable, which means they can change depending on market conditions and your credit score. In general, these rates are higher than those for personal loans.

What credit score is considered good for obtaining a line of credit?

Typically, lenders favour applicants with good to excellent credit scores, usually above 670, to qualify for a line of credit with the best terms. Nevertheless, some lenders might provide lines of credit to individuals with lower credit scores, albeit at higher interest rates.

Are there any charges linked to lines of credit?

Typical fees include annual fees, transaction fees, and cash advance fees. Make sure to fully grasp all the fees related to a line of credit before you apply.

How do I evaluate and compare lines of credit from various lenders?

Examine aspects such as interest rates, credit limits, fees, and repayment terms. Additionally, consider choosing lenders known for their excellent customer service.




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Published: 25 Mar 2024, 12:38 PM IST
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