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If you're like most people, there may be times in your life when you will want or need to borrow money. Perhaps you want to finance a big project to upgrade your home. Maybe you need money to pay taxes or an unexpected medical expense. You might even want a loan with a lower interest rate to consolidate debt you have taken out already.
Depending on your situation, a personal loan or a line of credit could help you accomplish your goals. While both types of financing might give you access to the funds you want, they work very differently.
A personal loan differs from a line of credit in that with a loan, you borrow a fixed amount of money and repay it at a fixed payment amount over a fixed period of time. Notice the trend? Personal loans are easier to budget for when compared with lines of credit. Yet lines of credit can offer you flexibility when borrowing. With a line of credit, you can borrow up to your maximum limit, repay the funds and borrow again as needed.
There are times when a line of credit might be your preferred choice, based on why you need to borrow money, and there are other times when a personal loan will be a better fit. Understanding the difference between these two financial products can go a long way toward helping you choose the option that's best for you.
Personal Loan vs. Line of Credit
Personal loans are sometimes called signature loans. They get this name due to the fact that if you qualify, you can receive the loan with just your signature. Because the loan is unsecured, you don't have to put up any assets or collateral, such as a home or vehicle, to secure financing.
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Lines of credit, on the other hand, behave like credit card accounts. You can borrow, pay down your balance and access your available credit line again and again. Like a personal loan, you may be able to qualify for an unsecured personal line of credit with just your signature. However, if you secure your line of credit with an asset, you may receive a better interest rate.
How to Qualify
Because personal loans and lines of credit are two different financial products, they each have different qualification demands. The main difference between the two is that lenders may require your credit to be in better shape to be approved for a line of credit.
Every lender is different, of course. But most lenders will want you to meet the following criteria to qualify for a personal loan or line of credit:
- Good to exceptional credit rating
- Acceptable debt-to-income ratio
- Proof of stable income
Remember, it's a good idea to check your credit on your own before you apply for any type of loan or financial product. You don't want to find out about any surprises or mistakes on your credit report when a lender processes your application.
The Application Process
The process to apply for a personal loan or a line of credit is similar. First, a lender will review your credit report and score, along with your income and assets, to determine whether extending credit to you is a good risk. The better your credit, the better your odds of approval for either type of financing.
Here's one of the biggest differences between applying for a personal loan and a line of credit: With a personal loan, you need to know upfront how much money you want to borrow.
Interest Rates
When you take out a personal loan, you are typically charged interest on the money you borrowed beginning on day one of the loan. In general, you will be charged a fixed interest rate. This means your interest rate stays the same throughout the life of your loan.
Interest rates on personal loans largely depend on your credit and your lender. Average rates can range from a little over 4% for borrowers with exceptional credit to as high as 25% for borrowers with poor credit.
While lines of credit may offer you more flexibility, this typically comes at a cost—namely a higher interest rate. Yet unlike personal loans, that interest rate doesn't kick in as soon as you're approved. Rather, you start paying interest on a line of credit once you access any portion of the funds available to you. In addition, the rates on lines of credit are variable and can change over time.
How Much Can You Borrow?
Figuring out how much you can borrow will depend on a variety of factors, such as your income, your credit and the maximum amount of money a lender is willing to issue. As mentioned above, when you take out a personal loan, you receive your full loan amount in one lump sum. On a line of credit, you can borrow up to your account limit. However, provided your account remains in good standing, you can make payments to reduce your balance and then borrow back up to your account limit again, as needed.
Repaying the Money You Borrowed
In addition to fixed interest rates, personal loans generally feature a fixed payment amount as well. This means that the size of your monthly payment won't change while you're repaying your loan. Fixed payments can make budgeting simpler. It's easy to plan your monthly expenses when you know the exact amount you're expected to pay on your personal loan.
Your monthly payments on a line of credit can vary widely from month to month and year to year. This happens because your monthly payment will be based on how much you owe along with the current interest rate on your account. (Remember, lines of credit feature variable interest rates, which are subject to change.)
When Should I Choose a Personal Loan?
You can use a personal loan for a variety of reasons. The freedom to use the money you borrow as you see fit (for the most part) is one of the features that makes personal loans attractive to so many people.
If you're looking for a list of ways to use a personal loan, here's a helpful guide. Additionally, here are a few common reasons why people take out personal loans:
- Debt consolidation
- Major medical expenses
- Fixed-price home repairs
There are also several potential benefits to using a personal loan over other types of financing when you need to borrow money. These include:
- Lower interest rates
- No collateral necessary
- Fixed rates and payments
Again, as with any type of financing, the condition of your credit will impact the rates and terms you're offered on a personal loan. This is just one more example of how having good credit can pay off.
When Should I Choose a Personal Line of Credit?
Lines of credit represent a flexible borrowing option that can be helpful if you don't know in advance how much money you'll need to finance a particular project. Examples of times you might want to use a personal line of credit include:
- Home remodeling projects
- Ongoing projects with unknown costs
People with variable incomes may benefit from lines of credit as well, to help them cover expenses during gaps in income.
Some of the benefits of using a personal line of credit when you need to borrow money include:
- Flexible borrowing options for expenses spread out over time
- Quick access to funds on as-needed basis
Keep in mind, if you don't have good personal credit, you may find that qualifying for a line of credit is more difficult. Also, while lines of credit can often be cheaper than credit cards, you could possibly qualify for a personal loan with a lower interest rate.
Making the Choice
The bottom line is this: If you can figure out which financial product fits your situation best, there's a chance you could save money and simplify your life.
If you take out a personal loan that winds up being too small to cover costs on a big project, you could end up having to borrow again. This means the hassle of another application and the potential for your credit to be impacted negatively by an extra account and inquiry. On the other hand, if you take out a line of credit when you don't really need one, you might be charged a higher interest rate than you could have qualified for with a personal loan.
Do your homework, including a credit check, before you decide which product to apply for and which lender to use. If you take your time and don't rush into a decision, you can be confident that you're choosing the best deal for your situation.