When you borrow money, it’s important you understand exactly how your loan works. You’ll need to know how much money you’re allowed to borrow, what interest you’ll pay, and when and how you’ll pay back the loan.
Two of the most popular ways to borrow money are personal loans and lines of credit. While both of these types of loans can come from banks, credit unions, or online lenders, they work very differently. It’s important for any would-be borrower to understand the variances between them to decide which is the best option.
This guide will explain the key differences between personal loans and lines of credit including:
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- When and how you receive your funds
- How much flexibility you have when it comes to borrowing
- How interest will be charged
- How your loan is repaid
When do you get money from a personal loan vs. a line of credit?
When you take out a personal loan, you usually borrow a fixed amount and receive the entire amount up front. For example, if you take out a $10,000 personal loan, the lender gives you a check for $10,000 or deposits $10,000 in your bank account.
If you’re given a $10,000 line of credit, your lender doesn’t just give you $10,000 when you sign the loan paperwork. Instead, you’re given the chance to borrow up to $10,000 at any time while your line of credit remains open.
You could borrow $6,000 and then pay it all back; borrow $9,000 and then borrow an additional $500; pay back $5,000 of what you owe; then borrow another $1,000; and so on.
The key is you can’t ever borrow more than your line of credit — but you could borrow less.
How much flexibility do you have when it comes to borrowing?
With a personal loan, you and your lender agree up front to the terms of the loan — and you don’t get to borrow more even as you pay down what you owe.
If you’ve taken out a $10,000 personal loan and paid off $8,000 of it when you suddenly decide you need to borrow another $8,000, you’re out of luck. Your lender isn’t just going to give you more money. You’d have to apply for a new loan.
With a line of credit, on the other hand, you have lots of flexibility in when and how much you borrow. You may be given a $10,000 line of credit and not need to draw any money from it for five months or for two years. Then, you may need to borrow the entire $10,000 all at once. And once you’ve paid some of it back, you may need to borrow again.
Lines of credit are ideal to have available in case of emergencies because you can take out only as much money as you need and only when you need it (of course, an emergency fund would be better because you don’t have to pay interest!).
How is interest charged?
Personal loans are more likely to have fixed interest rates, while lines of credit are more likely to have variable rates.
When you have a fixed interest rate loan, you will know exactly how much interest you’ll owe each month and during the life of the loan. Since you also know up front how much you’re borrowing with a personal loan, there will be no surprises during the time you’re paying off your debt.
When your loan or line of credit has a variable rate, the interest rate you’ll pay is tied to a financial index such as the LIBOR index. This means your interest rate could go up or sometimes go down. If your interest rate changes, the payments you’re making and the total cost of the debt you owe could also change.
Personal loans also often, but not always, have lower interest rates than lines of credit do. Of course, your specific rate will depend on your credit score and other qualifying factors.
How is your loan repaid?
Personal loans are typically repaid on a fixed monthly schedule. This schedule is designed to ensure you pay enough principal and interest each month so your debt will be fully paid off by the end of the loan repayment term.
With a line of credit, on the other hand, things don’t work quite so simply and you don’t have a set payment you make each month. Instead, once you start to draw from your line of credit, you repay what you owe in accordance with the lender’s policies.
Different lenders have different rules for exactly how much you’ll have to pay each month that you borrowed from your line of credit. For example, you may be required to pay the greater of $25 or 1.5% of the amount you borrowed.
This means your payment can vary greatly from one month to another. It also means there’s no fixed schedule for when your loan is fully paid off, since your balance and payments could change over time as you borrow more or less.
Which is better for you, a personal loan or a line of credit?
Both personal loans and lines of credit have their place and borrowers need to consider their own specific situation when determining what their best approach to borrowing is. Just remember the key differences between personal loans and lines of credit:
- Personal loans provide a fixed amount of funds you receive all at once; lines of credit allow you to borrow up to your credit limit but you don’t have to borrow all the money at one time.
- Personal loans are more likely to have fixed interest rates; lines of credit are more likely to have variable rates and the interest rate may be higher than with a personal loan.
- Personal loans are repaid on a predictable set schedule, while payments fluctuate on lines of credit based on how much you’ve borrowed and what the current interest rate is on your debt.
If you need to borrow money for a specific purpose, you know how much you need to borrow, and you want certainty in your repayment schedule, a personal loan is the right choice. But if you want to have money available to borrow and pay back as you need it, a line of credit is a better option for your situation.
Whether you choose a personal loan or a line of credit, it’s important to shop around with different lenders, see which lender offers you the best rates and terms, and make sure the loan is affordable for your specific financial situation. And try to keep your borrowing to a minimum so you don’t end up enriching creditors with your interest payments while your debt jeopardizes your financial goals.
View more information: https://www.fool.com/the-ascent/personal-loans/articles/whats-difference-between-personal-loan-and-line-credit/